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3. Each job receives a predetermined amount of supplies based on a study of each job’s needs. 4. In the storeroom, the supplies clerk notes the levels of supplies and com- pletes the purchase requisition when new supplies are needed. 5. The purchase requisition goes to the purchasing clerk, a new position. The purchasing clerk is solely responsible for authorizing purchases and preparing the purchase orders. 6. Supplier prices are monitored constantly by the purchasing clerk to ensure that the lowest price is obtained. 7. When supplies are received, the supplies clerk checks them in and prepares a receiving report. The supplies clerk sends the receiving report to accounting, where each payment to a supplier is documented by the purchase requisition, the purchase order, and the receiving report. 8. The accounting department also maintains a record of supplies inventory, supplies requisitioned by supervisors, and supplies received. 9. Once each month, the warehouse manager takes a physical inventory of clean- ing supplies in the storeroom and compares it against the supplies inventory records that the accounting department maintains. Required 1. Indicate which of the following control activities applies to each of the improvements in the internal control system (more than one may apply): a. Authorization b. Recording transactions c. Documents and records d. Physical controls e. Periodic independent verification f. Separation of duties g. Sound personnel practices User insight (cid:2) 2. Explain why each new control activity is an improvement over the activities of the old system. SO4 Imprest (Petty Cash) Fund Transactions P 7. On July 1, 2011, Acton Company established an imprest (petty cash) fund in the amount of $400.00 in cash from a check drawn for the purpose of estab- lishing the fund. On July 31, the petty cash fund has cash of $31.42 and the fol- lowing receipts on hand: for merchandise received, $204.30; freight-in, $65.74; laundry service, $84.00; and miscellaneous expense, $14.54. A check was drawn to replenish the fund. Chapter Assignments 347 On Aug. 31, the petty cash fund has cash of $55.00 and the following receipts on hand: merchandise, $196.84; freight-in, $76.30; laundry service, $84.00; and miscellaneous expense, $7.86. The petty cash custodian is not able to account for the excess cash in the fund. A check is drawn to replenish the fund. Required 1. In journal form, prepare the entries necessary to record each of these transac- tions. The company uses the periodic inventory system. User insight (cid:2) 2. What are two examples of why a local semiprofessional baseball team might have need for an imprest (petty cash) system? LO2 LO3 Internal Control Activities P 8. Fleet’s is a retail store with several departments. Its internal control proce- dures for cash sales and purchases are as follows: Cash sales. The sales clerk in each department rings up every cash sale on the department’s cash register. The cash register produces a sales slip, which the clerk gives to the customer along with the merchandise. A continuous tape locked inside the cash register makes a carbon copy of the sales ticket. At the end of each day, the sales clerk presses a “total” key on the register, and it prints the total sales for the day on the continuous tape. The sales clerk then unlocks the tape, reads the total sales figure, and makes the entry in the accounting records for the day’s cash sales. Next, she counts the cash in the drawer, places the $100 change fund back in the drawer, and gives the cash received to the cashier. Finally, she files the cash register tape and is ready for the next day’s business. Purchases. At the request of the various department heads, the purchas- ing agent orders all goods. When the goods arrive, the receiving clerk prepares a receiving report in triplicate. The receiving clerk keeps one copy; the other two copies go to the purchasing agent and the department head. Invoices are for- warded immediately to the accounting department to ensure payment before the discount period elapses. After payment, the invoice is forwarded to the purchasing

agent for comparison with the purchase order and the receiving report and is then returned to the accounting office for filing. Required 1. Identify the significant internal control weaknesses in each of the above situations. 2. In each case identified in requirement 1, recommend changes that would improve the system. ENHANCING Your Knowledge, Skills, and Critical Thinking LO2 LO3 Control Systems C 1. In the spring of each year, Steinbrook College’s theater department puts on a contemporary play. Before the performance, the theater manager instructs stu- dent volunteers in their duties as cashier, ticket taker, and usher. The cashier, who is located in a box office at the entrance to the auditorium, receives cash from customers and enters the number of tickets and the amount paid into a computer, which prints out serially numbered tickets. The cashier puts the cash in a locked cash drawer and gives the tickets to the customer. 348 CHAPTER 7 Internal Control Customers give their tickets to the ticket taker. The ticket taker tears each ticket in half, gives one half to the customer, and puts the other half in a locked box. When customers present their ticket stubs to an usher, the usher shows them to their seats. 1. Describe how the control activities discussed in this chapter (authorization; recording transactions; documents and records; physical controls; periodic independent verification; separation of duties; and sound personnel practices) apply to the cashier, ticket taker, and usher. 2. Could the cashier issue a ticket to a friend without taking in cash? Could the ticket taker allow friends to enter without a ticket? If so, how might they be caught? LO2 LO3 Internal Control Lapse C 2. Starbucks Corporation accused an employee and her husband of embez- zling $3.7 million by billing the company for services from a fictitious consulting firm. The couple had created a phony company called RAD Services Inc. and charged Starbucks for work they never provided. The employee worked in Star- bucks’ Information Technology Department. RAD Services Inc. charged Star- bucks as much as $492,800 for consulting services in a single week.8 For such a fraud to have taken place, certain control activities were likely not implemented. Identify and describe these control activities. LO1 Personal Responsibility for Mistakes C 3. Suppose you have a part-time sales position over the winter break in a small clothing store that is part of a national chain. The store’s one full-time employee, with whom you have become friendly, hired you. Explain what you would do in the situations described below, and identify two internal control problems that exist in each situation. 1. You arrive at the store at 6 P.M. to take over the evening shift from the full- time employee who hired you. You notice that this person takes a coat from a rack, puts it on, and leaves by the back door. You are not sure if the coat is one that was for sale or if it belonged to the employee. 2. You are the only person in the store on a busy evening. At closing time, you total the cash register and the receipts and discover that the cash register is $20 short of cash. You consider replacing the $20 out of your pocket because you think you may have made a mistake and are afraid you might lose your job if the company thinks you took the money. LO2 LO3 Internal Controls C 4. Go to a local retail business, such as a bookstore, clothing shop, gift shop, grocery store, hardware store, or car dealership. Ask to speak to someone who is knowledgeable about the store’s methods of internal control. After you and other members of the class have completed this step individually, your instructor will divide the class into groups. Group members will compare their findings and develop answers to the questions that follow. A member of each group will then present the group’s answers to the class. 1. How does the company protect itself against inventory theft and loss? 2. What control activities, including authorization, recording transactions, docu- ments and records, physical controls, periodic independent verification, separa-

tion of duties, and sound personnel practices, does the company use? 3. Can you see these control procedures in use? Chapter Assignments 349 LO1 Recognition, Valuation, and Classification C 5. To answer the following questions, refer to “Management’s Report on Internal Control Over Financial Reporting” and the “Report of Independent Registered Public Accounting Firm” in CVS’s annual report in the Supplement to Chapter 5: 1. What is management’s responsibility with regard to internal control over financial reporting? 2. What is management’s conclusion regarding its assessment of internal con- trol over financial reporting? 3. Does CVS’s auditor agree with management’s assessment? 4. What does the auditor say about the limitations or risks associated with inter- nal control? LO2 Contrasting Internal Control Needs C 6. In a typical CVS store, customers wheel carts down aisles to select items for purchase and take them to a checkout counter where they pay with cash or credit card. The company is concerned that customers might leave the store with mer- chandise that they have not paid for. Typically, customers of Southwest Airlines have already paid for their tickets when they arrive at the gate. The company is concerned that customers who do not have tickets might be allowed on the plane. (Southwest does not have assigned seating.) Compare the risks for each company in the situations just described and the internal control procedures that are needed. C H A P T E R 8 Inventories F or any company that makes or sells merchandise, inventory is Making a Statement an extremely important asset. Managing this asset is a chal- lenging task. It requires not only protecting goods from theft or INCOME STATEMENT loss but also ensuring that operations are highly efficient. Further, Revenues as you will see in this chapter, proper accounting of inventory is – Expenses essential because misstatements will affect net income in at least = Net Income two years. STATEMENT OF OWNER’S EQUITY LEARNING OBJECTIVES Beginning Balance + Net Income LO1 Explain the management decisions related to inventory – Withdrawals accounting, evaluation of inventory level, and the effects of = Ending Balance inventory misstatements on income measurement. (pp. 352–358) LO2 Define inventory cost, contrast goods flow and cost flow, and BALANCE SHEET explain the lower-of-cost-or-market (LCM) rule. (pp. 358–360) Assets Liabilities LO3 Calculate inventory cost under the periodic inventory system Owner’s using various costing methods. (pp. 361–364) Equity A = L + OE LO4 Explain the effects of inventory costing methods on income determination and income taxes. (pp. 365–367) STATEMENT OF CASH FLOWS Operating activities + Investing activities SUPPLEMENTAL OBJECTIVES + Financing activities = Change in Cash + Beginning Balance SO5 Calculate inventory cost under the perpetual inventory system = Ending Cash Balance using various costing methods. (pp. 367–370) SO6 Use the retail method and gross profit method to estimate the Valuation of inventories affects the amount of cost of ending inventory. (pp. 370–372) inventories on the balance sheet and the cost of goods sold on the income statement. 350 DECISION POINT (cid:2) A USER’S FOCUS (cid:2) How should Snugs Company decide which inventory system SNUGS COMPANY and costing method to use? (cid:2) How do decisions about Snugs Company is a new store that sells a variety of stylish leather inventory evaluation and boots and bags. Because Snugs is a merchandising company, inven- inventory levels affect operating results? tory is a very important component of its total assets, and the deci- sions that George Lopez, the company’s owner, makes about how to account for inventory can have a significant impact on its oper- ating results. As you will learn in this chapter, George has several decisions to make, including which inventory system and costing method to use, how to value inventory, and how much inventory to keep in stock. 335511 352 CHAPTER 8 Inventories Managing Inventory is considered a current asset because a company normally sells it within

Inventories a year or within its operating cycle. For a merchandising company like CVS or Walgreens, inventory consists of all goods owned and held for sale in the regular course of business. Because manufacturing companies like Toyota are engaged in LO1 Explain the management making products, they have three kinds of inventory: decisions related to inven- tory accounting, evaluation of (cid:2) Raw materials (goods used in making products) inventory level, and the effects of inventory misstatements on (cid:2) Work in process (partially completed products) income measurement. (cid:2) Finished goods ready for sale In a note to its financial statements, Toyota showed the following breakdown of its inventories (figures are in millions):1 Inventories 2008 2007 Raw materials (includes supplies) $ 2,990 $ 3,072 Work in process 2,395 2,006 Finished goods 12,093 10,203 Total inventories $17,478 $15,281 The work in process and the finished goods inventories have three cost components: (cid:2) Cost of the raw materials that go into the product (cid:2) Cost of the labor used to convert the raw materials to finished goods (cid:2) Overhead costs that support the production process Overhead costs include the costs of indirect materials (such as packing materials), indirect labor (such as the salaries of supervisors), factory rent, depreciation of plant assets, utilities, and insurance. Inventory Decisions The primary objective of inventory accounting is to determine income properly Study Note by matching costs of the period against revenues for the period. As you can see in Figure 8-1, in accounting for inventory, management must choose among differ- Management considers the behavior of inventory prices ent processing systems, costing methods, and valuation methods. These different over time when selecting systems and methods usually result in different amounts of reported net income. inventory costing methods. Thus, management’s choices affect investors’ and creditors’ evaluations of a com- pany, as well as internal evaluations, such as the performance reviews on which bonuses and executive compensation are based. The consistency convention requires that once a company has decided on the systems and methods it will use in accounting for inventory, it must use them from one accounting period to the next unless management can justify a change. If a change is justifiable, the full disclosure convention requires that the notes to the financial statements clearly explain the change and its effects. Because the valuation of inventory affects income, it can have a consider- able impact on the amount of income taxes a company pays—and the amount of taxes it pays can have a considerable impact on its cash flows. Federal income tax regulations are specific about the valuation methods a company may use. As a result, management is sometimes faced with the dilemma of how to apply GAAP to income determination and still minimize income taxes. Managing Inventories 353 FIGURE 8-1 INVENTORY INVENTORY INVENTORY Management Choices in Accounting PROCESSING COSTING VALUATION for Inventories SYSTEMS METHODS METHODS • Periodic • Specific • Cost • Perpetual identification • Market (if lower • Average-cost than cost) • First-in, first-out (FIFO) • Last-in, first-out (LIFO) A PPLICATION OF MATCHING RULE to COST OF GOODS AVAILABLE FOR SALE determines COST OF GOODS SOLD ENDING INVENTORY Evaluating the Level of Inventory Study Note The level of inventory a company maintains has important economic conse- quences. Ideally, management wants to have a great variety and quantity of goods Some of the costs of carrying inventory are insurance, on hand so that customers have a large choice and do not have to wait for an item property tax, and storage costs. to be restocked. But implementing such a policy can be expensive. Handling and Other costs may result from storage costs and the interest cost of the funds needed to maintain high inventory spoilage and employee theft. levels are usually substantial. On the other hand, low inventory levels can result in

disgruntled customers and lost sales. FOCUS ON BUSINESS PRACTICE A Whirlwind Inventory Turnover—How Does Dell Do It? Dell Computer Corporation turns its inventory over every from Dell’s factories, making efficient, just-in-time operations 5 days. How can it do this when other computer companies possible. Another time and money saver is the handling of have inventory on hand for 60 days or even longer? Tech- computer monitors. Monitors are no longer shipped first to nology and good inventory management are a big part of Dell and then on to buyers. Dell sends an e-mail message to the answer. a shipper, such as United Parcel Service, and the shipper Dell’s speed from order to delivery sets the standard for picks up a monitor from a supplier and schedules it to arrive the computer industry. Consider that a computer ordered with the PC. In addition to contributing to a high inventory by 9 a.m. can be delivered the next day by 9 p.m. How can turnover, this practice saves Dell about $30 per monitor in Dell do this when it does not start ordering components and freight costs. Dell is showing the world how to run a busi- assembling computers until a customer places an order? First, ness in the cyber age by selling more than $1 million worth of Dell’s suppliers keep components warehoused just minutes computers a day on its website.2 354 CHAPTER 8 Inventories One measure that managers commonly use to evaluate inventory levels is inven- tory turnover, which is the average number of times a company sells its inventory during an accounting period. It is computed by dividing cost of goods sold by average inventory. For example, using Nike’s Annual Report we can compute the company’s inventory turnover for 2009 as follows (figures are in millions): Cost of Goods Sold Inventory Turnover (cid:2) Average Inventory $10,571.7 (cid:2) ($2,357.0 (cid:3) $2,438.4) (cid:5) 2 $10,571.7 (cid:2) (cid:2) 4.4 Times $2,397.7 FIGURE 8-2 Times Inventory Turnover for Selected Auto and 4.6 Industries Home Supply Grocery 13.5 Stores Machinery 6.2 Computers 4.0 0 2 4 6 8 10 12 14 Merchandising Industries Manufacturing Industries Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006. Another common measure of inventory levels is days’ inventory on hand, which is the average number of days it takes a company to sell the inventory it has in stock. For Nike, it is computed as follows: Number of Days in a Year Days’ Inventory on Hand (cid:2) Inventory Turnover (cid:2) 365 Days (cid:2) 83.0 Days 4.4 Times FIGURE 8-3 Days Days’ Inventory on Hand Auto and 79.3 for Selected Industries Home Supply Grocery 27.0 Stores Machinery 58.9 Computers 91.2 0 10 20 30 40 50 60 70 80 90 100 Merchandising Industries Manufacturing Industries Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006. Nike turned its inventory over 4.4 times in 2009 or, on average, every 83.0 days. Thus, it had to provide financing for the inventory for almost three months before it sold it. To reduce their levels of inventory, many merchandisers and manufactur- ers use supply-chain management in conjunction with a just-in-time operating environment. With supply-chain management, a company uses the Internet to Managing Inventories 355 FOCUS ON BUSINESS PRACTICE What Do You Do to Cure a Bottleneck Headache? A single seat belt can have as many as 50 parts, and getting through the Internet rather than through faxes and phone the parts from suppliers was once a big problem for Autoliv, calls. This system allowed suppliers to monitor the inventory Inc., a Swedish maker of auto safety devices. Autoliv’s plant at Autoliv and thus to anticipate problems. It also provided in Indianapolis was encountering constant bottlenecks in information on quantity and time of recent shipments, as dealing with 125 different suppliers. To keep the produc- well as continuously updated forecasts of parts that would tion lines going required high-priced, rush shipments on a be needed in the next 12 weeks. With supply-chain man- daily basis. To solve the problem, the company began using agement, Autoliv reduced inventory by 75 percent and rush

supply-chain management, keeping in touch with suppliers freight costs by 95 percent.3 order and track goods that it needs immediately. A just-in-time operating envi- Study Note ronment is one in which goods arrive just at the time they are needed. Inventory turnover will be Nike uses supply-chain management to increase inventory turnover. It man- systematically higher if year-end ages its inventory purchases through business-to-business transactions that it inventory levels are low. For conducts over the Internet. It also uses a just-in-time operating environment in example, many merchandisers’ which it works closely with suppliers to coordinate and schedule shipments so year-end is in January when that the shipments arrive exactly when needed. The benefits of using supply- inventories are lower than at chain management in a just-in-time operating environment are that Nike has less any other time of the year. money tied up in inventory and its cost of carrying inventory is reduced. Effects of Inventory Misstatements on Income Measurement The reason inventory accounting is so important to income measurement is the way income is measured on the income statement. Recall that gross margin is the difference between net sales and cost of goods sold and that cost of goods sold depends on the portion of cost of goods available for sale assigned to ending inventory. These relationships lead to the following conclusions: (cid:2) The higher the value of ending inventory, the lower the cost of goods sold and the higher the gross margin. (cid:2) Conversely, the lower the value of ending inventory, the higher the cost of goods sold and the lower the gross margin. Because the amount of gross margin has a direct effect on net income, the value assigned to ending inventory also affects net income. In effect, the value of end- ing inventory determines what portion of the cost of goods available for sale is assigned to cost of goods sold and what portion is assigned to the balance sheet as inventory to be carried over into the next accounting period. The basic issue in separating goods available for sale into two components— goods sold and goods not sold—is to assign a value to the goods not sold, the ending inventory. The portion of goods available for sale not assigned to the ending inventory is used to determine the cost of goods sold. Because the figures for ending inventory and cost of goods sold are related, a misstatement in the inventory figure at the end of an accounting period will cause an equal misstate- ment in gross margin and income before income taxes in the income statement. The amount of assets and stockholders’ equity on the balance sheet will be mis- stated by the same amount. Inventory is particularly susceptible to fraudulent financial report- ing. For example, it is easy to overstate or understate inventory by including 356 CHAPTER 8 Inventories end-of-the-year purchase and sales transactions in the wrong fiscal year or by simply misstating inventory. A misstatement can occur because of mistakes in the accounting process. It can also occur because of deliberate manipulation of oper- ating results motivated by a desire to enhance the market’s perception of the company, obtain bank financing, or achieve compensation incentives. In one spectacular case, Rite Aid Corporation, the large drugstore chain, fal- sified income by manipulating its computerized inventory system to cover losses from shoplifting, employee theft, and spoilage. In another case, bookkeepers at RentWay, Inc., a company that rents furniture to apartment dwellers, boosted income artificially over several years by overstating inventory in small increments that were not noticed by top management. Whatever the causes of an overstatement or understatement of inventory, the three examples that follow illustrate the effects. In each case, beginning inventory, net cost of purchases, and cost of goods available for sale are stated correctly. In Example 1, ending inventory is correctly stated; in Example 2, it is overstated by

$3,000; and in Example 3, it is understated by $3,000. Example 1. Ending Inventory Correctly Stated at $5,000 Cost of Goods Sold for the Year Income Statement for the Year Beginning inventory $ 6,000 Net sales $ 50,000 Net cost of purchases 29,000 Cost of goods sold 30,000 Cost of goods available for sale $35,000 Gross margin $ 20,000 Ending inventory 5,000 Operating expenses 16,000 Income before income Cost of goods sold $30,000 taxes $ 4,000 Example 2. Ending Inventory Overstated by $3,000 Cost of Goods Sold for the Year Income Statement for the Year Beginning inventory $ 6,000 Net sales $ 50,000 Net cost of purchases 29,000 Cost of goods sold 27,000 Cost of goods available for sale $35,000 Gross margin $ 23,000 Ending inventory 8,000 Operating expenses 16,000 Income before income Cost of goods sold $27,000 taxes $ 7,00 0 Example 3. Ending Inventory Understated by $3,000 Cost of Goods Sold for the Year Income Statement for the Year Beginning inventory $ 6,000 Net sales $ 50,000 Net cost of purchases 29,000 Cost of goods sold 33,000 Cost of goods available for sale $35,000 Gross margin $ 17,000 Ending inventory 2,000 Operating expenses 16,000 Income before income Cost of goods sold $33,000 taxes $ 1,000 In all three examples, the cost of goods available for sale was $35,000. The difference in income before income taxes resulted from how this $35,000 was divided between ending inventory and cost of goods sold. Managing Inventories 357 Autoliv’s use of supply-chain man- agement is an example of how this system has benefited businesses. By using the Internet to order and track the numerous parts involved in the manufacture of the seat belts pictured here, Autoliv prevented delays in the shipments of parts by allowing its sup- pliers to monitor inventory and thus to anticipate problems. The firm also drastically reduced its inventory and freight costs. Courtesy of Kathy Wynn/Dreamstime. Because the ending inventory in one period becomes the beginning inven- Study Note tory in the following period, a misstatement in inventory valuation affects not A misstatement of inventory only the current period but the following period as well. Over two periods, has the opposite effect in two the errors in income before income taxes will offset, or counterbalance, each successive accounting periods. other. For instance, in Example 2, the overstatement of ending inventory will cause a $3,000 overstatement of beginning inventory in the following year, which will result in a $3,000 understatement of income. Because the total income before income taxes for the two periods is the same, it may appear that one need not worry about inventory misstatements. However, the mis- statements violate the matching rule. In addition, management, creditors, and investors base many decisions on the accountant’s determination of net income. The accountant has an obligation to make the net income figure for each period as useful as possible. The effects of inventory misstatements on income before income taxes are as follows: Year 1 Year 2 Ending inventory overstated Beginning inventory overstated Cost of goods sold understated Cost of goods sold overstated Income before income taxes Income before income taxes overstated understated Ending inventory understated Beginning inventory understated Cost of goods sold overstated Cost of goods sold understated Income before income taxes Income before income taxes understated overstated 358 CHAPTER 8 Inventories STOP & APPLY During 2010, Max’s Sporting Goods had beginning inventory of $500,000, ending inventory of $700,000, and cost of goods sold of $2,100,000. Compute the inventory turnover and days’ inventory on hand. SOLUTION Inventory Turnover (cid:2) Cost of Goods Sold/Average Inventory (cid:2) _ ______$ __2 _,1 _0 __0 _,0 _0 __0 _ ______ (cid:2) _$ _2 _, _1 _0 _ 0 _, _0 _0 _0 _ ($700,000 (cid:3) $500,000)/2 $600,000 (cid:2) 3.5 Times Days’ Inventory on Hand (cid:2) 365/Inventory Turnover (cid:2) 365/3.5(cid:2) 104.3 Days Inventory Cost The primary basis of accounting for inventories is cost, the price paid to acquire

and Valuation an asset. Inventory cost includes the following: (cid:2) Invoice price less purchases discounts LO2 Define inventory cost, con- (cid:2) Freight-in, including insurance in transit trast goods flow and cost flow, and explain the lower-of-cost-or- (cid:2) Applicable taxes and tariffs market (LCM) rule. Other costs—for ordering, receiving, and storing—should in principle be included in inventory cost. In practice, however, it is so difficult to allocate such costs to specific inventory items that they are usually considered expenses of the account- ing period rather than inventory costs. Inventory costing and valuation depend on the prices of the goods in inven- tory. The prices of most goods vary during the year. A company may have pur- chased identical lots of merchandise at different prices. Also, when a company deals in identical items, it is often impossible to tell which have been sold and which are still in inventory. When that is the case, it is necessary to make an assumption about the order in which items have been sold. Because the assumed order of sale may or may not be the same as the actual order of sale, the assump- tion is really about the flow of costs rather than the flow of physical inventory. Goods Flows and Cost Flows GGoods flow refers to the actual physical movement of goods in the operations of a Study Note ccompany. Cost flow refers to the association of costs with their assumed flow in the ooperations of a company. The assumed cost flow may or may not be the same as the The assumed flow of inventory aactual goods flow. The possibility of a difference between cost flow and goods flow costs does not have to mmay seem strange at first, but it arises because several choices of assumed cost flow are correspond to the physical flow aavailable under generally accepted accounting principles. In fact, it is sometimes pref- of goods. eerable to use an assumed cost flow that bears no relationship to goods flow because it ggives a better estimate of income, which is the main goal of inventory valuation. Merchandise in Transit Because merchandise inventory includes all items that a company owns and holds for sale, the status of any merchandise in transit, whether the company is selling it or buying it, must be evaluated to see if the merchandise should be included in the inventory count. Neither the seller nor the buyer has physical possession of merchandise in transit. As Figure 8-4 shows, ownership is determined by the terms of the shipping agreement, which indicate when title Inventory Cost and Valuation 359 FIGURE 8-4 Merchandise in Transit GOODS IN TRANSIT Shipping point SELLER’S WAREHOUSE Destination TERMS FOB shipping point: buyer owns inventory in transit. CUSTOMER’S STORE FOB destination: seller owns inventory in transit. passes. Outgoing goods shipped FOB (free on board) destination are included in the seller’s merchandise inventory, whereas those shipped FOB shipping point are not. Conversely, incoming goods shipped FOB shipping point are included in the buyer’s merchandise inventory, but those shipped FOB destination are not. Merchandise on Hand Not Included in Inventory At the time a com- pany takes a physical inventory, it may have merchandise on hand to which it does not hold title. For example, it may have sold goods but not yet delivered them to the buyer, but because the sale has been completed, title has passed to the buyer. Thus, the merchandise should be included in the buyer’s inventory, not the seller’s. Goods held on consignment also fall into this category. A consignment is merchandise that its owner (the consignor) places on the premises of another company (the consignee) with the understanding that pay- ment is expected only when the merchandise is sold and that unsold items may be returned to the consignor. Title to consigned goods remains with the consignor until the consignee sells the goods. Consigned goods should not be included in the consignee’s physical inventory because they still belong to the consignor. Study Note Lower-of-Cost-or-Market (LCM) Rule

Cost must be determined by AAlthough cost is usually the most appropriate basis for valuation of inventory, one of the inventory costing iinventory may at times be properly shown in the financial statements at less than methods before it can be iits historical, or original, cost. If the market value of inventory falls below its compared with the market hhistorical cost because of physical deterioration, obsolescence, or decline in price value. llevel, a loss has occurred. This loss is recognized by writing the inventory down FOCUS ON BUSINESS PRACTICE Lower of Cost or Market Can Be Costly When the lower-of-cost-or-market rule comes into play, it final products.4 In another case, through poor manage- can be an indication of how bad things are for a company. ment, a downturn in the economy, and underperforming When the market for Internet and telecommunications stores, Kmart, the discount department store, found itself equipment had soured, Cisco Systems, a large Internet with a huge amount of excess merchandise, including more supplier, found itself faced with probably the largest inven- than 5,000 truckloads of goods stored in parking lots, which tory loss in history. It had to write down to zero almost it could not sell except at drastically reduced prices. The two-thirds of its $2.5 billion inventory, 80 percent of which company had to mark down its inventory by $1 billion in consisted of raw materials that would never be made into order to sell it, which resulted in a debilitating loss.5 360 CHAPTER 8 Inventories FOCUS ON BUSINESS PRACTICE Is “Market” the Same as Fair Value? When the lower-of-cost-or-market rule is used, what does cost or the amount at which the asset can be purchased. “market” mean? Under IFRS, market is determined to be fair The two “market” values, selling price and purchasing price, value, which is understood to be the amount at which an can often be quite different for the same asset. This is an asset can be sold. However, under U.S. standards, market in issue that will have to be addressed if the U.S. and interna- valuing inventory is normally considered to be replacement tional standards are to achieve convergence. to market—that is, to its current replacement cost. For a merchandising com- pany, market is the amount that it would pay at the present time for the same goods, purchased from the usual suppliers and in the usual quantities. When the replacement cost of inventory falls below its historical cost (as deter- mined by an inventory costing method), the lower-of-cost-or-market (LCM) rule requires that the inventory be written down to the lower value and that a loss be recorded. This rule is an example of the application of the conservatism convention because the loss is recognized before an actual transaction takes place. Under historical cost accounting, the inventory would remain at cost until it is sold. According to an AICPA survey, approximately 80 percent of 600 large com- panies apply the LCM rule to their inventories for financial reporting.6 Disclosure of Inventory Methods The full disclosure convention requires that companies disclose their inventory methods, including the use of LCM, in the notes to their financial statements, and users should pay close attention to them. For example, Toyota discloses that it uses the lower-of-cost-or-market method in this note to its financial statements: Inventories are valued at cost, not in excess of market, cost being deter- mined on the “average cost” basis. . . .7 STOP & APPLY Match the letter of each item below with the numbers of the related items: a. An inventory cost ____ 3. Application of the LCM rule b. An assumption used in the valuation of ____ 4. Goods flow inventory ____ 5. T ransportation charge for merchan- c. Full disclosure convention dise shipped FOB shipping point d. Conservatism convention ____ 6. Cost flow e. Consistency convention ____ 7. C hoosing a method and sticking f. Not an inventory cost or assumed flow with it ____ 1. Cost of consigned goods ____ 8. T ransportation charge for merchan-

dise shipped FOB destination ____ 2. A note to the financial statements explaining inventory policies SOLUTION 1. f; 2. c; 3. d; 4. b; 5. a; 6. f; 7. e; 8. f Inventory Cost Under the Periodic Inventory System 361 Inventory Cost The value assigned to ending inventory is the result of two measurements: quan- tity and cost. As you know, under the periodic inventory system, quantity is Under the Periodic determined by taking a physical inventory; under the perpetual inventory system, Inventory System quantities are updated as purchases and sales take place. Cost is determined by using one of the following methods, each based on a different assumption of cost LO3 Calculate inventory cost flow: under the periodic inventory 1. Specific identification method system using various costing methods. 2. Average-cost method 3. First-in, first-out (FIFO) method 4. Last-in, first-out (LIFO) method The choice of method depends on the nature of the business, the financial effects Study Note of the method, and the cost of implementing the method. To illustrate how each method is used under the periodic inventory system, If the prices of merchandise we use the following data for April, a month in which prices were rising: purchased never changed, there would be no need for inventory April 1 Inventory 160 units @ $10.00 $ 1,600 methods. It is price changes that 6 Purchase 440 units @ $12.50 5,500 necessitate some assumption about the order in which goods 25 Purchase 400 units @ $14.00 5,600 are sold. Goods available for sale 1,000 units $12,700 Sales 560 units On hand April 30 440 units The problem of inventory costing is to divide the cost of the goods available for sale ($12,700) between the 560 units sold and the 440 units on hand. Specific Identification Method The specific identification method identifies the cost of each item in ending inventory. It can be used only when it is possible to identify the units in ending inventory as coming from specific purchases. For instance, if the April 30 inven- tory consisted of 100 units from the April 1 inventory, 200 units from the April 6 purchase, and 140 units from the April 25 purchase, the specific identification method would assign the costs as follows: Periodic Inventory System—Specific Identification Method 100 units @ $10.00 $1,000 Cost of goods available 200 units @ $12.50 2,500 for sale $12,700 140 units @ $14.00 1,960 Less April 30 inventory 5,460 440 units at a cost of $5,460 Cost of goods sold $ 7,240 The specific identification method may appear logical, and it can be used by companies that deal in high-priced articles, such as works of art, precious gems, or rare antiques. However, most companies do not use it for the following reasons: 1. It is usually impractical, if not impossible, to keep track of the purchase and sale of individual items. 2. When a company deals in items that are identical but that it bought at differ- ent prices, deciding which items were sold becomes arbitrary. If the company were to use the specific identification method, it could raise or lower income by choosing the lower- or higher-priced items. 362 CHAPTER 8 Inventories Average-Cost Method Under the average-cost method, inventory is priced at the average cost of the goods available for sale during the accounting period. Average cost is computed by dividing the total cost of goods available for sale by the total units available for sale. This gives an average unit cost that is applied to the units in ending inventory. In our illustration, the ending inventory would be $5,588, or $12.70 per unit, determined as follows: Periodic Inventory System—Average-Cost Method Cost of Goods Available for Sale (cid:5) Units Available for Sale (cid:2) Average Unit Cost $12,700 (cid:5) 1,000 units (cid:2) $12.70 Ending inventory: 440 units @ $12.70 (cid:2) $ 5,588 Cost of goods available for sale $12,700 Less April 30 inventory 5,588 Cost of goods sold $ 7,112 The average-cost method tends to level out the effects of cost increases and decreases because the cost of the ending inventory is influenced by all the prices

paid during the year and by the cost of beginning inventory. Some analysts, how- ever, criticize this method because they believe recent costs are more relevant for income measurement and decision making. First-In, First-Out (FIFO) Method The first-in, first-out (FIFO) method assumes that the costs of the first items Study Note acquired should be assigned to the first items sold. The costs of the goods on hand at the end of a period are assumed to be from the most recent purchases, Because of their perishable and the costs assigned to goods that have been sold are assumed to be from the nature, some products, such as milk, require a physical flow earliest purchases. Any business, regardless of its goods flow, can use the FIFO of first-in, first-out. However, method because the assumption underlying it is based on the flow of costs, not the inventory method used the flow of goods. to account for them can be In our illustration, the FIFO method would result in an ending inventory of based on an assumed cost flow $6,100, computed as follows: that differs from FIFO, such as average-cost or LIFO. Periodic Inventory System—FIFO Method 400 units @ $14.00 from purchase of April 25 $ 5,600 40 units @ $12.50 from purchase of April 6 500 440 units at a cost of $ 6,100 Cost of goods available for sale $12,700 Less April 30 inventory 6,100 Cost of goods sold $ 6,600 Thus, the FIFO method values ending inventory at the most recent costs and includes earlier costs in cost of goods sold. During periods of rising prices, FIFO yields the highest possible amount of net income because cost of goods sold shows the earliest costs incurred, which are lower during periods of infla- tion. Another reason for this is that businesses tend to raise selling prices as costs increase, even when they purchased the goods before the cost increase. In periods of declining prices, FIFO tends to charge the older and higher prices against Inventory Cost Under the Periodic Inventory System 363 FOCUS ON BUSINESS PRACTICE How Widespread Is LIFO? Achieving convergence in inventory methods between U.S. use different inventory methods for different portions of and international accounting standards will be very difficult. their inventory as long as there is proper disclosure. Interna- As may be seen in Figure 8-6 (on page 366), LIFO is the sec- tional standards only allow this practice in very limited cases. ond most popular inventory method in the United States. Also, as noted earlier in the chapter, U.S. and international However, outside the United States, hardly any companies standards have different ways of measuring “market” value use LIFO because it is not allowed under international finan- of inventories. Because these differences are so significant, cial reporting standards (IFRS). Further, U.S. companies may there is no current effort to resolve them.8 revenues, thus reducing income. Consequently, a major criticism of FIFO is that it magnifies the effects of the business cycle on income. Last-In, First-Out (LIFO) Method The last-in, first-out (LIFO) method of costing inventories assumes that the Study Note costs of the last items purchased should be assigned to the first items sold and Physical flow under LIFO can Periodic Inventory System—LIFO Method be likened to the changes in a 160 units @ $10.00 from April 1 inventory $ 1,600 gravel pile as the gravel is sold. As the gravel on top leaves the 280 units @ $12.50 from purchase of April 6 3,500 pile, more is purchased and 440 units at a cost of $ 5,100 added to the top. The gravel on Cost of goods available for sale $12,700 the bottom may never be sold. Less April 30 inventory 5,100 Although the physical flow is Cost of goods sold $ 7,600 last-in, first-out, any acceptable cost flow assumption can be made. that the cost of ending inventory should reflect the cost of the goods purchased earliest. Under LIFO, the April 30 inventory would be $5,100: The effect of LIFO is to value inventory at the earliest prices and to include the cost of the most recently purchased goods in the cost of goods sold. This

assumption, of course, does not agree with the actual physical movement of ggoods in most businesses. There is, however, a strong logical argument to Study Note ssupport LIFO. A certain size of inventory is necessary in a going concern— wwhen inventory is sold, it must be replaced with more goods. The supporters In inventory valuation, the flow oof LIFO reason that the fairest determination of income occurs if the current of costs—and hence income ccosts of merchandise are matched against current sales prices, regardless of determination—is more wwhich physical units of merchandise are sold. When prices are moving either important than the physical uup or down, the cost of goods sold will, under LIFO, show costs closer to the movement of goods and pprice level at the time the goods are sold. Thus, the LIFO method tends to balance sheet valuation. sshow a smaller net income during inflationary times and a larger net income dduring deflationary times than other methods of inventory valuation. The peaks and valleys of the business cycle tend to be smoothed out. An argument can also be made against LIFO. Because the inventory valua- tion on the balance sheet reflects earlier prices, it often gives an unrealistic picture of the inventory’s current value. Balance sheet measures like working capital and current ratio may be distorted and must be interpreted carefully. 364 CHAPTER 8 Inventories FIGURE 8-5 Cost of Goods Available for Sale The Impact of Costing Methods on the $12,700 Income Statement and Balance Sheet Under the Periodic Inventory System Specific $7,240 $5,460 Identification Average-Cost $7,112 $5,588 FIFO $6,600 $6,100 LIFO $7,600 $5,100 Income Statement—Cost of Goods Sold Balance Sheet—Inventory Summary of Inventory Costing Methods Figure 8-5 summarizes how the four inventory costing methods affect the cost of goods sold on the income statement and inventory on the balance sheet when a company uses the periodic inventory system. In periods of rising prices, FIFO yields the highest inventory valuation, the lowest cost of goods sold, and hence a higher net income; LIFO yields the lowest inventory valuation, the highest cost of goods sold, and thus a lower net income. STOP & APPLY Match the following inventory costing methods to the statements below for which they are true: (a) Average cost, (b) LIFO, or (c) FIFO ____ 1. In periods of rising prices, this ____ 4. In periods of decreasing prices, this method results in the highest cost of method results in neither the high- goods sold. est inventory cost nor the lowest income. ____ 2. In periods of rising prices, this method results in the highest ____ 5. In periods of decreasing prices, this income. method results in the lowest income. ____ 3. In periods of rising prices, this ____ 6. In periods of decreasing prices, this method results in the lowest ending method results in the highest cost of inventory cost. goods sold. SOLUTION 1. c; 2. b; 3. c; 4. a; 5. b; 6. b Impact of Inventory Decisions 365 Impact of Table 8-1 shows how the specific identification, average-cost, FIFO, and LIFO methods of pricing inventory affect gross margin. The table uses the same data as Inventory in the previous section and assumes April sales of $10,000. Decisions Keeping in mind that April was a period of rising prices, you can see in Table 8-1 that LIFO, which charges the most recent—and, in this case, the highest— LO4 Explain the effects of prices to cost of goods sold, resulted in the lowest gross margin. Conversely, inventory costing methods FIFO, which charges the earliest—and, in this case, the lowest—prices to cost on income determination and of goods sold, produced the highest gross margin. The gross margin under the income taxes. average-cost method falls between the gross margins produced by LIFO and FIFO, so this method clearly has a less pronounced effect. During a period of declining prices, the LIFO method would produce a higher gross margin than the FIFO method. It is apparent that both these methods have the greatest impact on gross margin during prolonged periods of price changes,

whether up or down. Because the specific identification method depends on the particular items sold, no generalization can be made about the effect of changing prices on gross margin. Effects on the Financial Statements As Figure 8-6 shows, the FIFO, LIFO, and average-cost methods of inventory costing are widely used. Each method has its advantages and disadvantages— none is perfect. Among the factors managers should consider in choosing an inventory costing method are the trend of prices and the effects of each method on financial statements, income taxes, and cash flows. As we have pointed out, inventory costing methods have different effects on the income statement and balance sheet. The LIFO method is best suited for the income statement because it matches revenues and cost of goods sold. But it is not the best method for valuation of inventory on the balance sheet, particularly during a prolonged period of price increases or decreases. FIFO, on the other hand, is well suited to the balance sheet because the ending inventory is closest to current values and thus gives a more realistic view of a company’s current assets. Readers of financial statements must be alert to the inventory methods a com- Study Note ppany uses and be able to assess their effects. In periods of rising prices, LIFO EEffects on Income Taxes results in lower net income and TThe Internal Revenue Service governs how inventories must be valued for federal thus lower taxes. iincome tax purposes. IRS regulations give companies a wide choice of inventory TABLE 8-1 Specific Effects of Inventory Costing Methods Identification Average-Cost FIFO LIFO on Gross Margin Method Method Method Method Sales $ 10,000 $10,000 $10,000 $10,000 Cost of goods sold Beginning inventory $ 1,600 $ 1,600 $ 1,600 $ 1,600 Purchases 11,100 11,100 11,100 11,100 Cost of goods available for sale $ 12,700 $12,700 $12,700 $12,700 Less ending inventory 5,460 5,588 6,100 5,100 Cost of goods sold $ 7,240 $ 7,112 $ 6,600 $ 7,600 Gross margin $ 2,760 $ 2,888 $ 3,400 $ 2,400 366 CHAPTER 8 Inventories FIFO 64% LIFO 38% Average-Cost 27% Other 5% 0 10 20 30 40 50 60 70 Percentage of Companies Using Method* *Totalsmorethan100%duetouseofmorethanonemethod. costing methods, including specific identification, average-cost, FIFO, and LIFO, and, except when the LIFO method is used, it allows them to apply the lower-of- cost-or-market rule. However, if a company wants to change the valuation method it uses for income tax purposes, it must have advance approval from the IRS.* This requirement conforms to the consistency convention. A company should change its inventory method only if there is a good reason to do so. The company must show the nature and effect of the change in its financial statements. Many accountants believe that using the FIFO and average-cost methods in periods of rising prices causes businesses to report more than their actual profit, resulting in excess payment of income tax. Profit is overstated because cost of goods sold is understated relative to current prices. Thus, the company must buy replacement inventory at higher prices, while additional funds are needed to pay income taxes. During periods of rapid inflation, billions of dollars reported as profits and paid in income taxes were believed to be the result of poor matching of current costs and revenues under the FIFO and average-cost methods. Conse- quently, many companies, believing that prices would continue to rise, switched to the LIFO inventory method. When a company uses the LIFO method to report income for tax purposes, the IRS requires that it use the same method in its accounting records, and, as we have noted, it disallows use of the LCM rule. The company may, however, use the LCM rule for financial reporting purposes. Over a period of rising prices, a business that uses the LIFO method may find that for balance sheet purposes, its inventory is valued at a figure far below what it currently pays for the same items. Management must monitor such a situation carefully, because if it lets the inventory quantity at year end fall below the level

at the beginning of the year, the company will find itself paying higher income taxes. Higher income before taxes results because the company expenses the his- torical costs of inventory, which are below current costs. When sales have reduced inventories below the levels set in prior years, it is called a LIFO liquidation— that is, units sold exceed units purchased for the period. Managers can prevent a LIFO liquidation by making enough purchases before the end of the year to restore the desired inventory level. Sometimes, how- ever, a LIFO liquidation cannot be avoided because products are discontinued or supplies are interrupted, as in the case of a strike. In 2006, 26 out of 600 large companies reported a LIFO liquidation in which their net income increased due to the matching of historical costs with present sales dollars.9 *A single exception to this rule is that when companies change to LIFO from another method, they do not need advance approval from the IRS. dohteM yrotnevnI FIGURE 8-6 Inventory Costing Methods Used by 600 Large Companies Source: From “Accounting Trends & Techniques” (New York: AICPA, 2007). Copyright © 2007 by American Institute of Certified Public Accountants. Reprinted with permission. Inventory Cost Under the Perpetual Inventory System 367 Effects on Cash Flows Generally speaking, the choice of accounting methods does not affect cash flows. For example, a company’s choice of average cost, FIFO, or LIFO does not affect what it pays for goods or the price at which it sells them. However, the fact that income tax law requires a company to use the same method for income tax purposes and financial reporting means that the choice of inventory method will affect the amount of income tax paid. Therefore, choosing a method that results in lower income will result in lower income taxes due. In most other cases where there is a choice of accounting method, a company may choose different methods for income tax computations and financial reporting. STOP & APPLY Match each of the descriptions listed below to these inventory costing methods: a. Specific identification ____ 5. R esults in the lowest net income in periods of inflation b. Average-cost ____ 6. M atches the oldest costs with recent c. First-in, first-out (FIFO) revenues d. Last-in, first-out (LIFO) ____ 7. R esults in the highest net income in ____ 1. M atches recent costs with recent periods of inflation revenues ____ 8. R esults in the highest net income in ____ 2. A ssumes that each item of inventory periods of deflation is identifiable ____ 9. T ends to level out the effects of ____ 3. R esults in the most realistic balance inflation sheet valuation ____ 10. I s unpredictable as to the effects of ____ 4. R esults in the lowest net income in inflation periods of deflation SOLUTION 1. d; 2. a; 3. c; 4. c; 5. d; 6. c; 7. c; 8. d; 9. b; 10. a Inventory Cost Under the perpetual inventory system, cost of goods sold is accumulated as sales are made and costs are transferred from the Inventory account to the Cost Under the of Goods Sold account. The cost of the ending inventory is the balance of the Perpetual Inventory account. To illustrate costing methods under the perpetual inventory Inventory System system, we use the following data: Inventory Data—April 30 SO5 Calculate inventory cost April 1 Inventory 160 units @ $10.00 under the perpetual inventory 6 Purchase 440 units @ $12.50 system using various costing 10 Sale 560 units methods. 25 Purchase 400 units @ $14.00 30 Inventory 440 units The specific identification method produces the same inventory cost and cost of goods sold under the perpetual system as under the periodic system because 368 CHAPTER 8 Inventories cost of goods sold and ending inventory are based on the cost of the identified Study Note items sold and on hand. The detailed records of purchases and sales maintained The costs of an automated under the perpetual system facilitate the use of the specific identification method. perpetual system are The average-cost method uses a different approach under the perpetual and

considerable. They include the periodic systems, and it produces different results. Under the periodic system, costs of automating the system, the average cost is computed for all goods available for sale during the period. maintaining the system, and Under the perpetual system, an average is computed after each purchase or series taking a physical inventory. of purchases, as follows: Perpetual Inventory System—Average-Cost Method April 1 Inventory 160 units @ $10.00 $1,600 6 Purchase 440 units @ $12.50 5,500 6 Balance 600 units @ $11.83* $7,100 (new average computed) 10 Sale 560 units @ $11.83* (6,625) 10 Balance 40 units @ $11.83* $ 475 25 Purchase 400 units @ $14.00 5,600 30 Inventory 440 units @ $13.81* $6,075 (new average computed) Cost of goods sold $6,625 The costs applied to sales become the cost of goods sold, $6,625. The ending inventory is the balance, $6,075. When costing inventory with the FIFO and LIFO methods, it is necessary to keep track of the components of inventory at each step of the way because as sales are made, the costs must be assigned in the proper order. The FIFO method is applied as follows: Perpetual Inventory System—FIFO Method April 1 Inventory 160 units @ $10.00 $1,600 6 Purchase 440 units @ $12.50 5,500 10 Sale 160 units @ $10.00 ($1,600) 400 units @ $12.50 (5,000) (6,600) 10 Balance 40 units @ $12.50 $ 500 25 Purchase 400 units @ $14.00 5,600 30 Inventory 40 units @ $12.50 $ 500 400 units @ $14.00 5,600 $6,100 Cost of goods sold $6,600 Note that the ending inventory of $6,100 and the cost of goods sold of $6,600 are the same as the figures computed earlier under the periodic inventory system. This will always occur because the ending inventory under both systems consists of the last items purchased—in this case, the entire purchase of April 25 and 40 units from the purchase of April 6. *Rounded Inventory Cost Under the Perpetual Inventory System 369 FOCUS ON BUSINESS PRACTICE More Companies Enjoy LIFO! The availability of better technology may partially account The development of faster and less expensive computer for the increasing use of LIFO in the United States. Using systems has made it easier for companies that use the per- the LIFO method under the perpetual inventory system has petual inventory system to switch to LIFO and enjoy that always been a tedious process, especially if done manually. method’s economic benefits. The LIFO method is applied as follows: Perpetual Inventory System—LIFO Method April 1 Inventory 160 units @ $10.00 $1,600 6 Purchase 440 units @ $12.50 5,500 10 Sale 440 units @ $12.50 ($5,500) 120 units @ $10.00 (1,200) (6,700) 10 Balance 40 units @ $10.00 $ 400 25 Purchase 400 units @ $14.00 5,600 30 Inventory 40 units @ $10.00 $ 400 400 units @ $14.00 5,600 $6,000 Cost of goods sold $6,700 Notice that the ending inventory of $6,000 includes 40 units from the beginning inventory and 400 units from the April 25 purchase. Figure 8-7 compares the average-cost, FIFO, and LIFO methods under the perpetual inventory system. The rank of the results is the same as under the peri- odic inventory system, but some amounts have changed. For example, LIFO has the lowest balance sheet inventory valuation regardless of the inventory system used, but the amount is $6,000 using the perpetual system versus $5,100 using the periodic system. FIGURE 8-7 Cost of Goods Available for Sale The Impact of Costing Methods on the $12,700 Income Statement and Balance Sheet Under the Perpetual Inventory System Average-Cost $6,625 $6,075 FIFO $6,600 $6,100 LIFO $6,700 $6,000 Income Statement—Cost of Goods Sold Balance Sheet—Inventory 370 CHAPTER 8 Inventories STOP & APPLY Make the calculations asked for below given the following data: Inventory Data—April 30 May 1 Inventory 100 units @ $4.00 5 Purchase 200 units @ $5.00 6 Sale 250 units Using the perpetual inventory system, determine the cost of good sold associated with the sale on May 6 under the following methods: (a) average-cost, (b) FIFO, and (c) LIFO SOLUTION a. Average-cost method: 100 units (cid:6) $4 $ 400 200 units (cid:6) $5 1,000

300 units $1,400 $1,400/300(cid:2) $4.67 per unit Cost of good sold (cid:2) 250 units (cid:6) $4.67 (cid:2) $1,168* b. FIFO method: 100 units (cid:6) $4.00 $ 400 150 units (cid:6) $5.00 750 Cost of goods sold $1,150 c. LIFO method: 200 units (cid:6) $5.00 $1,000 50 units (cid:6) $4.00 200 Cost of goods sold $1,200 *Rounded Valuing Inventory It is sometimes necessary or desirable to estimate the value of ending inventory. by Estimation The retail method and gross profit method are most commonly used for this purpose. SO6 Use the retail method and gross profit method to Retail Method estimate the cost of ending The retail method estimates the cost of ending inventory by using the ratio of inventory. cost to retail price. Retail merchandising businesses use this method for two main reasons: Study Note 1. To prepare financial statements for each accounting period, one must know the cost of inventory; the retail method can be used to estimate the cost with- When estimating inventory by out taking the time or going to the expense of determining the cost of each the retail method, the inventory need not be counted. item in the inventory. 2. Because items in a retail store normally have a price tag or a universal product code, it is common practice to take the physical inventory at retail from these price tags or codes and to reduce the total value to cost by using the retail method. The term at retail means the amount of the inventory at the marked selling prices of the inventory items. Valuing Inventory by Estimation 371 TABLE 8-2 Cost Retail Retail Method of Inventory Estimation Beginning inventory $ 80,000 $110,000 Net purchases for the period (excluding freight-in) 214,000 290,000 Study Note Freight-in 6,000 Freight-in does not appear Goods available for sale $300,000 $400,000 in the Retail column because retailers automatically price Ratio of cost to retail price: $300,000 (cid:2) 75% $400,000 their goods high enough to cover freight charges. Net sales during the period 320,000 Estimated ending inventory at retail $ 80,000 Ratio of cost to retail 75% Estimated cost of ending inventory $ 60,000 When the retail method is used to estimate ending inventory, the records must show the beginning inventory at cost and at retail. They must also show the amount of goods purchased during the period at cost and at retail. The net sales at retail is the balance of the Sales account less returns and allowances. A simple example of the retail method is shown in Table 8-2. Goods available for sale is determined at cost and at retail by listing beginning inventory and net purchases for the period at cost and at their expected selling price, adding freight-in to the cost column, and totaling. The ratio of these two amounts (cost to retail price) provides an estimate of the cost of each dollar of retail sales value. The estimated ending inventory at retail is then determined by deducting sales for the period from the retail price of the goods that were avail- able for sale during the period. The inventory at retail is then converted to cost on the basis of the ratio of cost to retail. The cost of ending inventory can also be estimated by applying the ratio of cost to retail price to the total retail value of the physical count of the ending inventory. Applying the retail method in practice is often more difficult than this simple example because of such complications as changes in retail price during the period, different markups on different types of merchandise, and varying vol- umes of sales for different types of merchandise. Gross Profit Method The gross profit method (also known as the gross margin method) assumes that the ratio of gross margin for a business remains relatively stable from year to year. The gross profit method is used in place of the retail method when records of the retail prices of beginning inventory and purchases are not available. It is a useful way of estimating the amount of inventory lost or destroyed by theft, fire, or other hazards; insurance companies often use it to verify loss claims. The gross profit

method is acceptable for estimating the cost of inventory for interim reports, but it is not acceptable for valuing inventory in the annual financial statements. As Table 8-3 shows, the gross profit method is simple to use. First, figure the cost of goods available for sale in the usual way (add purchases to beginning inventory). Second, estimate the cost of goods sold by deducting the estimated gross margin of 30 percent from sales. Finally, deduct the estimated cost of goods sold from the goods available for sale to arrive at the estimated cost of ending inventory. 372 CHAPTER 8 Inventories TABLE 8-3 1. Beginning inventory at cost $100,000 Gross Profit Method of Inventory Estimation Purchases at cost (including freight-in) 580,000 Cost of goods available for sale $680,000 2. Less estimated cost of goods sold Sales at selling price $800,000 Less estimated gross margin ($800,000 (cid:6) 30%) 240,000 Estimated cost of goods sold 560,000 3. Estimated cost of ending inventory $120,000 STOP & APPLY Campus Jeans Shop had net retail sales of $195,000 during the current ayear. The following addi- tional information was obtained from the company’s accounting records: At Cost At Retail Beginning inventory $ 40,000 $ 60,000 Net purchases (excluding freight-in) 130,000 210,000 Freight-in 10,000 Using the retail method, estimate the company’s ending inventory at cost. Assuming that a physi- cal inventory taken at year end revealed an inventory on hand of $66,000 at retail value, what is the estimated amount of inventory shrinkage (loss due to theft, damage, etc.) at cost using the retail method? SOLUTION Cost Retail Beginning inventory $ 40,000 $ 60,000 Net purchases for the period (excluding freight-in) 130,000 210,000 Freight-in 10,000 Goods available for sale $180,000 $270,000 Ratio of cost to retail price: $180,000 (cid:2) 66.7% $270,000 Net sales during the period 195,000 Estimated ending inventory at retail $ 84,000 Ratio of cost to retail 66.7% Estimated cost of ending inventory $ 56,000 Estimated inventory loss (cid:2) Estimated cost (cid:4) (Retail inventory count (cid:6) 2/3) (cid:2) $56,000 (cid:4) ($66,000 (cid:6) 2/3) (cid:2) $56,000 (cid:4) $44,000 (cid:2) $12,000 Snugs Company: Review Problem 373 (cid:2) SNUGS COMPANY: REVIEW PROBLEM In this chapter’s Decision Point, we posed the following questions: • How should Snugs Company decide which inventory system and costing method to use? • How do decisions about inventory evaluation and inventory levels affect operating results? In deciding whether Snugs Company should use the periodic or perpetual inventory sys- tem, George Lopez, the company’s owner, would choose the system that best achieves the company’s goals. In deciding about costing methods, George would need to see the numbers that the average-cost, FIFO, or LIFO costing methods produce under each inventory system. As you know from having read this chapter, the decisions that George Lopez or any Periodic and Perpetual other manager makes about the evaluation of inventory affect a company’s net income, the amount of taxes it pays, and its cash flows. Decisions about inventory levels also have Inventory Systems and important economic consequences: too low a level can result in disgruntled customers Inventory Ratios and too high a level can result in substantial storage, handling, and interest costs. LO1 LO3 The table that follows summarizes Snug Company’s beginning inventory, purchases, SO5 sales, and ending inventory in May: Required 1. Using the data for May and assuming that Snugs Company uses the periodic inventory system, compute the cost that should be assigned to ending inventory and to cost of goods sold using (a) the average-cost method, (b) the FIFO method, and (c) the LIFO method. 2. Using the same data and assuming that the company uses the perpetual inventory system, compute the cost that should be assigned to ending inventory and to cost of goods sold using (a) the average-cost method, (b) the FIFO method, and (c) the LIFO method. 3. Compute inventory turnover and days’ inventory on hand under each of the

inventory cost flow assumptions in 1. What conclusion can you draw from this comparison? Answers to Units Amount Review Problem Beginning inventory 2,800 $ 56,000 Purchases 2,800 64,800 Available for sale 5,600 $120,800 Sales 3,200 Ending inventory 2,400 374 CHAPTER 8 Inventories 1. Periodic inventory system: a. Average-cost method Cost of goods available for sale $120,800 Less ending inventory consisting of 2,400 units at $21.57* 51,768 Cost of goods sold $ 69,032 *$120,800 (cid:5) 5,600 units (cid:2) $21.57 (rounded) b. FIFO method Cost of goods available for sale $120,800 Less ending inventory consisting of May 24 purchase (1,600 (cid:6) $24) $38,400 May 8 purchase (800 (cid:6) $22) 17,600 56,000 Cost of goods sold $ 64,800 c. LIFO method Cost of goods available for sale $120,800 Less ending inventory consisting of beginning inventory (2,400 (cid:6) $20) 48,000 Cost of goods sold $ 72,800 2. Perpetual inventory system: a. Average-cost method Date Units Cost Amount May 1 Inventory 2,800 $20.00 $56,000 8 Purchase 1,200 22.00 26,400 8 Balance 4,000 20.60 $82,400 10 Sale (3,200) 20.60 (65,920) 10 Balance 800 20.60 $16,480 24 Purchase 1,600 24.00 38,400 31 Inventory 2,400 22.87* $54,880 Cost of goods sold $65,920 *Rounded. b. FIFO method Date Units Cost Amount May 1 Inventory 2,800 $20 $56,000 8 Purchase 1,200 22 26,400 8 Balance 2,800 20 1,200 22 $82,400 10 Sale (2,800) 20 (400) 22 (64,800) 10 Balance 800 22 $17,600 24 Purchase 1,600 24 38,400 31 Inventory 800 22 1,600 24 $56,000 Cost of goods sold $64,800 Snugs Company: Review Problem 375 c. LIFO method Date Units Cost Amount May 1 Inventory 2,800 $20 $56,000 8 Purchase 1,200 22 26,400 8 Balance 2,800 20 1,200 22 $82,400 10 Sale (1,200) 22 (2,000) 20 (66,400) 10 Balance 800 20 $16,000 24 Purchase 1,600 24 38,400 31 Inventory 800 20 1,600 24 $54,400 Cost of goods sold $66,400 3. Ratios computed: Average-Cost FIFO LIFO Cost of Goods Sold $69,032 $64,800 $72,800 Average Inventory _ ($_ 5_ 1_ ,_ 7_ 6_ 8 _ (cid:3)__ $_ _ 5_ 6_ ,0 _ 0_ 0_ )_ (cid:5)__ 2_ (cid:2) _ ($_ 5_ 6_ ,_ 0_ 0_ 0 _ (cid:3)__ $_ _ 5_ 6_ ,0 _ 0_ 0_ )_ (cid:5)__ 2_ (cid:2) _ ($_ 4_ 8_ ,_ 0_ 0_ 0 _ (cid:3)__ $_ _ 5_ 6_ ,0 _ 0_ 0_ )_ (cid:5)__ 2_ (cid:2) $69,032 $64,800 $72,800 _______ (cid:2) 1.3 _ ______ (cid:2) 1.2 _______ (cid:2) 1.4 $53,884 $56,000 $52,000 Inventory Turnover: 1.3 times 1.2 times 1.4 times Days’ Inventory (365 days (cid:5) 1.3 times) (365 days (cid:5) 1.2 times) (365 days (cid:5) 1.4 times) on Hand: 280.8 days 304.2 days 260.7 days In periods of rising prices, the LIFO method will always result in a higher inven- tory turnover and lower days’ inventory on hand than the other costing methods. When comparing inventory ratios for two or more companies, their inventory methods should be considered. 376 CHAPTER 8 Inventories STOP & REVIEW LO1 Explain the manage- The objective of inventory accounting is the proper determination of income ment decisions related through the matching of costs and revenues. In accounting for inventories, man- to inventory accounting, agement must choose the type of processing system, costing method, and val- evaluation of inventory uation method the company will use. Because the value of inventory affects a level, and the eff ects of company’s net income, management’s choices will affect not only external and internal evaluations of the company but also the amount of income taxes the inventory misstatements company pays and its cash flows. on income measurement. The level of inventory a company maintains has important economic conse- quences. To evaluate inventory levels, managers commonly use inventory turn- over and its related measure, days’ inventory on hand. Supply-chain management and a just-in-time operating environment are a means of increasing inventory turnover and reducing inventory carrying costs. If the value of ending inventory is understated or overstated, a corresponding error—dollar for dollar—will be made in income before income taxes. Further- more, because the ending inventory of one period is the beginning inventory of the next, the misstatement affects two accounting periods, although the effects

are opposite. LO2 Defi ne inventory cost, Inventory cost includes the invoice price less purchases discounts; freight-in, contrast goods fl ow and including insurance in transit; and applicable taxes and tariffs. Goods flow refers cost fl ow, and explain the to the actual physical flow of merchandise in a business, whereas cost flow refers lower-of-cost-or-market to the assumed flow of costs. The lower-of-cost-or-market rule states that if the (LCM) rule. replacement cost (market cost) of the inventory is lower than the original cost, the lower figure should be used. LO3 Calculate inventory cost The value assigned to ending inventory is the result of two measurements: quan- under the periodic inven- tity and cost. Quantity is determined by taking a physical inventory. Cost is deter- tory system using vari- mined by using one of four inventory methods, each based on a different assump- tion of cost flow. Under the periodic inventory system, the specific identification ous costing methods. method identifies the actual cost of each item in inventory. The average-cost method assumes that the cost of inventory is the average cost of goods available for sale during the period. The first-in, first-out (FIFO) method assumes that the costs of the first items acquired should be assigned to the first items sold. The last-in, first-out (LIFO) method assumes that the costs of the last items acquired should be assigned to the first items sold. The inventory method used may or may not correspond to the actual physical flow of goods. LO4 Explain the eff ects of During periods of rising prices, the LIFO method will show the lowest net income; inventory costing FIFO, the highest; and average-cost, in between. LIFO and FIFO have the oppo- methods on income site effects in periods of falling prices. No generalization can be made regarding determination and the specific identification method. The Internal Revenue Service requires that if income taxes. LIFO is used for tax purposes, it must be used for financial statements; it also does not allow the lower-of-cost-or-market rule to be applied to the LIFO method. Stop & Review 377 Supplemental Objectives SO5 Calculate inventory cost Under the perpetual inventory system, cost of goods sold is accumulated as sales are under the perpetual made and costs are transferred from the Inventory account to the Cost of Goods Sold inventory system using account. The cost of the ending inventory is the balance of the Inventory account. various costing methods. The specific identification method and the FIFO method produce the same results under both the perpetual and periodic inventory systems. The results differ for the average-cost method because an average is calculated after each sale rather than at the end of the accounting period. Results also differ for the LIFO method because the cost components of inventory change constantly as goods are bought and sold. SO6 Use the retail method Two methods of estimating the value of inventory are the retail method and the and gross profi t method gross profit method. Under the retail method, inventory is determined at retail to estimate the cost of prices and is then reduced to estimated cost by applying a ratio of cost to retail price. Under the gross profit method, cost of goods sold is estimated by reducing ending inventory. sales by estimated gross margin. The estimated cost of goods sold is then deducted from the cost of goods available for sale to estimate the cost of ending inventory. REVIEW of Concepts and Terminology The following concepts and terms Inventory cost 358 (LO2) Retail method 370 (SO6) were introduced in this chapter: Just-in-time operating environment Specific identification method Average-cost method 362 (LO3) 355 (LO1) 361 (LO3) Consignment 359 (LO2) Last-in, first-out (LIFO) method Supply-chain management 354 (LO1) 363 (LO3) Cost flow 358 (LO2) LIFO liquidation 366 (LO4) Key Ratios First-in, first-out (FIFO) method 362 (LO3) Lower-of-cost-or-market (LCM) Days’ inventory on hand 354 (LO1) rule 360 (LO2)

Goods flow 358 (LO2) Inventory turnover 354 (LO1) Market 360 (LO2) Gross profit method 371 (SO6) 378 CHAPTER 8 Inventories CHAPTER ASSIGNMENTS BUILDING Your Basic Knowledge and Skills Short Exercises LO1 Management Issues SE 1. Indicate whether each of the following items is associated with (a) allocating the cost of inventories in accordance with the matching rule, (b) assessing the impact of inventory decisions, (c) evaluating the level of inventory, or (d) engaging in an unethical practice. 1. Calculating days’ inventory on hand 2. Ordering a supply of inventory to satisfy customer needs 3. Valuing inventory at an amount to achieve a specific profit objective 4. Calculating the income tax effect of an inventory method 5. Deciding the cost to place on ending inventory LO1 Inventory Turnover and Days’ Inventory on Hand SE 2. During 2010, Gabriella’s Fashion had beginning inventory of $960,000, ending inventory of $1,120,000, and cost of goods sold of $4,400,000. Com- pute the inventory turnover and days’ inventory on hand. LO3 Specific Identification Method SE 3. Assume the following data with regard to inventory for Caciato Company: Aug. 1 Inventory 40 units @ $10 per unit $ 400 8 Purchase 50 units @ $11 per unit 550 22 Purchase 35 units @ $12 per unit 420 Goods available for sale 125 units $1,370 Aug. 15 Sale 45 units 28 Sale 25 units Inventory, Aug. 31 55 units Assuming that the inventory consists of 30 units from the August 8 purchase and 25 units from the purchase of August 22, calculate the cost of ending inventory and cost of goods sold. LO3 Average-Cost Method: Periodic Inventory System SE 4. Using the data in SE 3, calculate the cost of ending inventory and cost of goods sold according to the average-cost method under the periodic inventory system. LO3 FIFO Method: Periodic Inventory System SE 5. Using the data in SE 3, calculate the cost of ending inventory and cost of goods sold according to the FIFO method under the periodic inventory system. LO3 LIFO Method: Periodic Inventory System SE 6. Using the data in SE 3, calculate the cost of ending inventory and cost of goods sold according to the LIFO method under the periodic inventory system. LO4 Effects of Inventory Costing Methods and Changing Prices SE 7. Using Table 8-1 as an example, prepare a table with four columns that shows the ending inventory and cost of goods sold for each of the results from Chapter Assignments 379 your calculations in SE 3 through SE 6, including the effects of the different prices at which the merchandise was purchased. Which method(s) would result in the lowest income taxes? SO5 Average-Cost Method: Perpetual Inventory System SE 8. Using the data in SE 3, calculate the cost of ending inventory and cost of goods sold according to the average-cost method under the perpetual inventory system. SO5 FIFO Method: Perpetual Inventory System SE 9. Using the data in SE 3, calculate the cost of ending inventory and cost of goods sold according to the FIFO method under the perpetual inventory system. SO5 LIFO Method: Perpetual Inventory System SE 10. Using the data in SE 3, calculate the cost of ending inventory and cost of goods sold according to the LIFO method under the perpetual inventory system. Exercises LO1 LO2 Discussion Questions E 1. Develop a brief answer to each of the following questions: 1. Is it good or bad for a retail store to have a large inventory? 2. Which is more important from the standpoint of inventory costing: the flow of goods or the flow of costs? 3. Why is misstatement of inventory one of the most common means of finan- cial statement fraud? 4. Given that the LCM rule is an application of the conservatism convention in the current accounting period, is the effect of this application also conserva- tive in the next period? LO4 SO5 Discussion Questions SO6 E 2. Develop a brief answer to each of the following questions: 1. Under what condition would all four methods of inventory pricing produce exactly the same results? 2. Under the perpetual inventory system, why is the cost of goods sold not determined by deducting the ending inventory from goods available for sale,

as it is under the periodic method? 3. Which of the following methods do not require a physical inventory: periodic inventory system, perpetual inventory method, retail method, or gross profit method? LO1 Management Issues E 3. Indicate whether each of the following items is associated with (a) allocating the cost of inventories in accordance with the matching rule, (b) assessing the impact of inventory decisions, (c) evaluating the level of inventory, or (d) engaging in an unethical action. 1. Computing inventory turnover 2. Valuing inventory at an amount to meet management’s targeted net income 3. Application of the just-in-time operating environment 4. Determining the effects of inventory decisions on cash flows 5. Apportioning the cost of goods available for sale to ending inventory and cost of goods sold 380 CHAPTER 8 Inventories 6. Determining the effects of inventory methods on income taxes 7. Determining the assumption about the flow of costs into and out of the company LO1 Inventory Ratios E 4. Just a Buck Discount Stores is assessing its levels of inventory for 2010 and 2011 and has gathered the following data: 2011 2010 2009 Ending inventory $ 96,000 $ 81,000 $69,000 Cost of goods sold 480,000 450,000 Compute the inventory turnover and days’ inventory on hand for 2010 and 2011 and comment on the results. LO1 Effects of Inventory Errors E 5. Condensed income statements for Kan-Du Company for two years are shown below. 2011 2010 Sales $504,000 $420,000 Cost of goods sold 300,000 216,000 Gross margin $204,000 $204,000 Operating expenses 120,000 120,000 Income before income taxes $ 84,000 $ 84,000 After the end of 2011, the company discovered that an error had resulted in a $36,000 understatement of the 2010 ending inventory. Compute the corrected operating income for 2010 and 2011. What effect will the error have on operating income and owner’s equity for 2012? LO1 LO2 LO3 Accounting Conventions and Inventory Valuation E 6. Turnbow Company, a telecommunications equipment company, has used the LIFO method adjusted for lower of cost or market for a number of years. Due to falling prices of its equipment, it has had to adjust (reduce) the cost of inventory to market each year for two years. The company is considering chang- ing its method to FIFO adjusted for lower of cost or market in the future. Explain how the accounting conventions of consistency, full disclosure, and conservatism apply to this decision. If the change were made, why would management expect fewer adjustments to market in the future? LO3 Periodic Inventory System and Inventory Costing Methods E 7. Gary’s Parts Shop recorded the following purchases and sales during the past year: Jan. 1 Beginning inventory 125 cases @ $46 $ 5,750 Feb. 25 Purchase 100 cases @ $52 5,200 June 15 Purchase 200 cases @ $56 11,200 Oct. 15 Purchase 150 cases @ $56 8,400 Dec. 15 Purchase 100 cases @ $60 6,000 Goods available for sale 675 $36,550 Total sales 500 cases Dec. 31 Ending inventory 175 cases Chapter Assignments 381 Assume that Gary’s Parts Shop sold all of the June 15 purchase and 100 cases each from the January 1 beginning inventory, the October 15 purchase, and the December 15 purchase. Determine the costs that should be assigned to ending inventory and cost of goods sold under each of the following assumptions: (1) costs are assigned by the specific identification method; (2) costs are assigned by the average-cost method; (3) costs are assigned by the FIFO method; (4) costs are assigned by the LIFO method. What conclusions can be drawn about the effect of each method on the income statement and the balance sheet of Gary’s Parts Shop? Round your answers to the nearest whole number and assume the periodic inventory system. LO3 Periodic Inventory System and Inventory Costing Methods E 8. During its first year of operation, Deja Vu Company purchased 5,600 units of a product at $21 per unit. During the second year, it purchased 6,000 units of the same product at $24 per unit. During the third year, it purchased 5,000 units at $30 per unit. Deja Vu Company managed to have an ending inventory each year of

1,000 units. The company uses the periodic inventory system. Prepare cost of goods sold statements that compare the value of ending inventory and the cost of goods sold for each of the three years using (1) the FIFO inventory costing method and (2) the LIFO method. From the resulting data, what conclusions can you draw about the relationships between the changes in unit price and the changes in the value of ending inventory? LO3 Periodic Inventory System and Inventory Costing Methods E 9. In chronological order, the inventory, purchases, and sales of a single prod- uct for a recent month are as follows: Amount Units per Unit June 1 Beginning inventory 150 $ 60 4 Purchase 400 66 12 Purchase 800 72 16 Sale 1,300 120 24 Purchase 300 78 Using the periodic inventory system, compute the cost of ending inventory, cost of goods sold, and gross margin. Use the average-cost, FIFO, and LIFO inven- tory costing methods. Explain the differences in gross margin produced by the three methods. Round unit costs to cents and totals to dollars. LO4 Effects of Inventory Costing Methods on Cash Flows E 10. Infinite Products, Inc., sold 120,000 cases of glue at $40 per case during 2010. Its beginning inventory consisted of 20,000 cases at a cost of $24 per case. During 2010, it purchased 60,000 cases at $28 per case and later 50,000 cases at $30 per case. Operating expenses were $1,100,000, and the applicable income tax rate was 30 percent. Using the periodic inventory system, compute net income using the FIFO method and the LIFO method for costing inventory. Which alternative produces the larger cash flow? The company is considering a purchase of 10,000 cases at $30 per case just before the year end. What effect on net income and on cash flow will this proposed purchase have under each method? (Hint: What are the income tax consequences?) 382 CHAPTER 8 Inventories SO5 Perpetual Inventory System and Inventory Costing Methods E 11. Referring to the data provided in E 9 and using the perpetual inventory system, compute the cost of ending inventory, cost of goods sold, and gross mar- gin. Use the average-cost, FIFO, and LIFO inventory costing methods. Explain the reasons for the differences in gross margin produced by the three methods. Round unit costs to cents and totals to dollars. LO3 SO5 Periodic and Perpetual Systems and Inventory Costing Methods E 12. During July 2010, Tricoci, Inc., sold 250 units of its product Empire for $4,000. The following units were available: Units Cost Beginning inventory 100 $ 2 Purchase 1 40 4 Purchase 2 60 6 Purchase 3 150 9 Purchase 4 90 12 A sale of 250 units was made after purchase 3. Of the units sold, 100 came from beginning inventory and 150 came from purchase 3. Determine cost of goods available for sale and ending inventory in units. Then determine the costs that should be assigned to cost of goods sold and ending inventory under each of the following assumptions: (1) Costs are assigned under the periodic inventory system using (a) the specific identifica- tion method, (b) the average-cost method, (c) the FIFO method, and (d) the LIFO method. (2) Costs are assigned under the perpetual inventory system using (a) the average-cost method, (b) the FIFO method, and (c) the LIFO method. For each alternative, show the gross margin. Round unit costs to cents and totals to dollars. SO6 Retail Method E 13. Olivia’s Dress Shop had net retail sales of $125,000 during the current year. The following additional information was obtained from the company’s account- ing records: At Cost At Retail Beginning inventory $20,000 $ 30,000 Net purchases (excluding freight-in) 70,000 110,000 Freight-in 5,200 1. Using the retail method, estimate the company’s ending inventory at cost. 2. Assume that a physical inventory taken at year end revealed an inventory on hand of $9,000 at retail value. What is the estimated amount of inven- tory shrinkage (loss due to theft, damage, etc.) at cost using the retail method? SO6 Gross Profit Method E 14. Chen Mo-Wan was at home when he received a call from the fire department telling him his store had burned. His business was a total loss.

The insurance company asked him to prove his inventory loss. For the year, until the date of the fire, Chen’s company had sales of $900,000 and pur- chases of $560,000. Freight-in amounted to $27,400, and beginning inven- tory was $90,000. Chen always priced his goods to achieve a gross margin of 40 percent. Compute Chen’s estimated inventory loss. Chapter Assignments 383 Problems LO1 LO3 Periodic Inventory System and Inventory Costing Methods P 1. El Faro Company merchandises a single product called Smart. The following data represent beginning inventory and purchases of Smart during the past year: January 1 inventory, 34,000 units at $11.00; February purchases, 40,000 units at $12.00; March purchases, 80,000 units at $12.40; May purchases, 60,000 units at $12.60; July purchases, 100,000 units at $12.80; September purchases, 80,000 units at $12.60; and November purchases, 30,000 units at $13.00. Sales of Smart totaled 393,000 units at $20.00 per unit. Selling and administrative expenses totaled $2,551,000 for the year. El Faro Company uses the periodic inventory system. Required 1. Prepare a schedule to compute the cost of goods available for sale. 2. Compute income before income taxes under each of the following inventory cost flow assumptions: (a) the average-cost method; (b) the FIFO method; and (c) the LIFO method. User insight (cid:2) 3. Compute inventory turnover and days’ inventory on hand under each of the inventory cost flow assumptions listed in requirement 2. What conclusion can you draw? LO1 LO3 Periodic Inventory System and Inventory Costing Methods P 2. The inventory of Product PIT and data on purchases and sales for a two- month period follow. The company closes its books at the end of each month. It uses the periodic inventory system. Apr. 1 Beginning inventory 50 units @ $204 10 Purchase 100 units @ $220 17 Sale 90 units 30 Ending inventory 60 units May 2 Purchase 100 units @ $216 14 Purchase 50 units @ $224 22 Purchase 60 units @ $234 30 Sale 200 units 31 Ending inventory 70 units Required 1. Compute the cost of ending inventory of Product PIT on April 30 and May 31 using the average-cost method. In addition, determine cost of goods sold for April and May. Round unit costs to cents and totals to dollars. 2. Compute the cost of the ending inventory on April 30 and May 31 using the FIFO method. In addition, determine cost of goods sold for April and May. 3. Compute the cost of the ending inventory on April 30 and May 31 using the LIFO method. In addition, determine cost of goods sold for April and May. User insight (cid:2) 4. Do the cash flows from operations for April and May differ depending on which inventory costing method is used—average-cost, FIFO, or LIFO? Explain. LO4 SO5 Perpetual Inventory System and Inventory Costing Methods P 3. Use the data provided in P 2, but assume that the company uses the per- petual inventory system. (Hint: In preparing the solutions required below, it is helpful to determine the balance of inventory after each transaction, as shown in the Review Problem in this chapter.) 384 CHAPTER 8 Inventories Required 1. Determine the cost of ending inventory and cost of goods sold for April and May using the average-cost method. Round unit costs to cents and totals to dollars. 2. Determine the cost of ending inventory and cost of goods sold for April and May using the FIFO method. 3. Determine the cost of ending inventory and cost of goods sold for April and May using the LIFO method. User insight (cid:2) 4. Assume that this company grows for many years in a long period of rising prices. How realistic do you think the balance sheet value for inventory would be and what effect would it have on the inventory turnover ratio? SO6 Retail Method P 4. Ptak Company operates a large discount store and uses the retail method to estimate the cost of ending inventory. Management suspects that in recent weeks there have been unusually heavy losses from shoplifting or employee pilferage. To estimate the amount of the loss, the company has taken a physical inventory and will compare the results with the estimated cost of inventory. Data from the

accounting records of Ptak Company are as follows: At Cost At Retail August 1 beginning inventory $102,976 $148,600 Purchases 143,466 217,000 Purchases returns and allowances (4,086) (6,400) Freight-in 1,900 Sales 218,366 Sales returns and allowances (1,866) August 31 physical inventory at retail 124,900 Required 1. Using the retail method, prepare a schedule to estimate the dollar amount of the store’s month-end inventory at cost. 2. Use the store’s cost to retail ratio to reduce the retail value of the physical inventory to cost. 3. Calculate the estimated amount of inventory shortage at cost and at retail. User insight (cid:2) 4. Many retail chains use the retail method because it is efficient. Why do you think using this method is an efficient way for these companies to operate? SO6 Gross Profit Method P 5. Rudy Brothers is a large retail furniture company that operates in two adja- cent warehouses. One warehouse is a showroom, and the other is used to store merchandise. On the night of June 22, 2011, a fire broke out in the storage ware- house and destroyed the merchandise stored there. Fortunately, the fire did not reach the showroom, so all the merchandise on display was saved. Although the company maintained a perpetual inventory system, its records were rather haphazard, and the last reliable physical inventory had been taken on December 31. In addition, there was no control of the flow of goods between the showroom and the warehouse. Thus, it was impossible to tell what goods should have been in either place. As a result, the insur- ance company required an independent estimate of the amount of loss. The insurance company examiners were satisfied when they received the following information: Chapter Assignments 385 Merchandise inventory on December 31, 2010 $363,700.00 Purchases, January 1 to June 22, 2011 603,050.00 Purchases returns, January 1 to June 22, 2011 (2,676.50) Freight-in, January 1 to June 22, 2011 13,275.00 Sales, January 1 to June 22, 2011 989,762.50 Sales returns, January 1 to June 22, 2011 (7,450.00) Merchandise inventory in showroom on June 22, 2011 100,740.00 Average gross margin 44% Required 1. Prepare a schedule that estimates the amount of the inventory lost in the fire. User insight (cid:2) 2. What are some other reasons management might need to estimate the amount of inventory? Alternate Problems LO1 LO3 Periodic Inventory System and Inventory Costing Methods P 6. The Jarmen Cabinet Company sold 2,200 cabinets during 2010 at $80 per cabinet. Its beginning inventory on January 1 was 130 cabinets at $28. Purchases made during the year were as follows: February 225 cabinets @ $31.00 April 350 cabinets @ $32.50 June 700 cabinets @ $35.00 August 300 cabinets @ $33.00 October 400 cabinets @ $34.00 November 250 cabinets @ $36.00 The company’s selling and administrative expenses for the year were $50,500. The company uses the periodic inventory system. Required 1. Prepare a schedule to compute the cost of goods available for sale. 2. Compute income before income taxes under each of the following inventory cost flow assumptions: (a) the average-cost method, (b) the FIFO method, and (c) the LIFO method. User insight (cid:2) 3. Compute inventory turnover and days’ inventory on hand under each of the inventory cost flow assumptions in requirement 2. What conclusion can you draw from this comparison? LO1 LO3 Periodic Inventory System and Inventory Costing Methods P 7. The inventory, purchases, and sales of Product CAT for March and April are listed below. The company closes its books at the end of each month. It uses the periodic inventory system. Mar. 1 Beginning inventory 60 units @ $98 10 Purchase 100 units @ $104 19 Sale 90 units 31 Ending inventory 70 units Apr. 4 Purchase 120 units @ $106 15 Purchase 50 units @ $108 23 Sale 200 units 25 Purchase 100 units @ $110 30 Ending inventory 140 units 386 CHAPTER 8 Inventories Required 1. Compute the cost of the ending inventory on March 31 and April 30 using the average-cost method. In addition, determine cost of goods sold for March and April. Round unit costs to cents and totals to dollars.

2. Compute the cost of the ending inventory on March 31 and April 30 using the FIFO method. Also determine cost of goods sold for March and April. 3. Compute the cost of the ending inventory on March 31 and April 30 using the LIFO method. Also determine cost of goods sold for March and April. User insight (cid:2) 4. Do the cash flows from operations for March and April differ depending on which inventory costing method is used—average-cost, FIFO, or LIFO? Explain. LO4 SO5 Perpetual Inventory System and Inventory Costing Methods P 8. Use the data provided in P 7, but assume that the company uses the per- petual inventory system. (Hint: In preparing the solutions required below, it is helpful to determine the balance of inventory after each transaction, as shown in the Review Problem in this chapter.) Required 1. Determine the cost of ending inventory and cost of goods sold for March and April using the average-cost method. Round unit costs to cents and totals to dollars. 2. Determine the cost of ending inventory and cost of goods sold for March and April using the FIFO method. 3. Determine the cost of ending inventory and cost of goods sold for March and April using the LIFO method. User insight (cid:2) 4. Assume that this company grows for many years in a long period of rising prices. How realistic do you think the balance sheet value for inventory would be and what effect would it have on the inventory turnover ratio? SO6 Retail Method P 9. Fuentes Company operates a large discount store and uses the retail method to estimate the cost of ending inventory. Management suspects that in recent weeks there have been unusually heavy losses from shoplifting or employee pilfer- age. To estimate the amount of the loss, the company has taken a physical inven- tory and will compare the results with the estimated cost of inventory. Data from the accounting records of Fuentes Company are as follows: At Cost At Retail October 1 beginning inventory $51,488 $ 74,300 Purchases 71,733 108,500 Purchases returns and allowances (2,043) (3,200) Freight-in 950 Sales 109,183 Sales returns and allowances (933) October 31 physical inventory at retail 62,450 Required 1. Using the retail method, prepare a schedule to estimate the dollar amount of the store’s month-end inventory at cost. 2. Use the store’s cost to retail ratio to reduce the retail value of the physical inventory to cost. Chapter Assignments 387 3. Calculate the estimated amount of inventory shortage at cost and at retail. User insight (cid:2) 4. Many retail chains use the retail method because it is efficient. Why do you think using this method is an efficient way for these companies to operate? SO6 Gross Profit Method P 10. Oakley Sisters is a large retail furniture company that operates in two adja- cent warehouses. One warehouse is a showroom, and the other is used to store merchandise. On the night of April 22, 2010, a fire broke out in the storage warehouse and destroyed the merchandise stored there. Fortunately, the fire did not reach the showroom, so all the merchandise on display was saved. Although the company maintained a perpetual inventory system, its records were rather haphazard, and the last reliable physical inventory had been taken on December 31. In addition, there was no control of the flow of goods between the showroom and the warehouse. Thus, it was impossible to tell what goods should have been in either place. As a result, the insurance company required an inde- pendent estimate of the amount of loss. The insurance company examiners were satisfied when they received the following information: Merchandise inventory on December 31, 2009 $ 727,400 Purchases, January 1 to April 22, 2010 1,206,100 Purchases returns, January 1 to April 22, 2010 (5,353) Freight-in, January 1 to April 22, 2010 26,550 Sales, January 1 to April 22, 2010 1,979,525 Sales returns, January 1 to April 22, 2010 (14,900) Merchandise inventory in showroom on April 22, 2010 201,480 Average gross margin 44% Required 1. Prepare a schedule that estimates the amount of the inventory lost in the fire.

User insight (cid:2) 2. What are some other reasons management might need to estimate the amount of inventory? ENHANCING Your Knowledge, Skills, and Critical Thinking LO1 Evaluation of Inventory Levels C 1. JCPenney, a large retail company with many stores, has an inventory turn- over of 3.7 times. Dell Computer Corporation, an Internet mail-order com- pany, has an inventory turnover of about 77.8. Dell achieves its high turnover through supply-chain management in a just-in-time operating environment. Why is inventory turnover important to companies like JCPenney and Dell? Why are comparisons among companies important? Are JCPenney and Dell a good match for comparison? Describe supply-chain management and a just-in-time operating environment. Why are they important to achieving a favorable inven- tory turnover? LO4 LIFO Inventory Method C 2. Seventy-six percent of chemical companies use the LIFO inventory method for the costing of inventories, whereas only 9 percent of computer equipment 388 CHAPTER 8 Inventories companies use LIFO.10 Describe the LIFO inventory method. What effects does it have on reported income, cash flows, and income taxes during periods of price changes? Why do you think so many chemical companies use LIFO while most companies in the computer industry do not? LO1 LO4 Inventories, Income Determination, and Ethics C 3. Jazz, Inc., which has a December 31 year end, designs and sells fashions for young professional women. Lyla Hilton, president of the company, fears that the forecasted 2010 profitability goals will not be reached. She is pleased when Jazz receives a large order on December 30 from The Executive Woman, a retail chain of upscale stores for businesswomen. Hilton immediately directs the controller to record the sale, which represents 13 percent of Jazz’s annual sales. At the same time, she directs the inventory control department not to separate the goods for shipment until after January 1. Separated goods are not included in inventory because they have been sold. On December 31, the company’s auditors arrive to observe the year-end tak- ing of the physical inventory under the periodic inventory system. How will Hil- ton’s actions affect Jazz’s 2010 profitability? How will they affect Jazz’s 2011 profitability? Were Hilton’s actions ethical? Why or why not? LO2 LO4 Retail Business Inventories C 4. Your instructor will assign teams to various types of stores in your com- munity—a grocery, clothing, book, music, or appliance store. Make an appoint- ment to interview the manager for 30 minutes to discuss the company’s inventory accounting system. The store may be a branch of a larger company. Ask the fol- lowing questions, summarize your findings in a paper, and be prepared to discuss your results in class: 1. What is the physical flow of merchandise into the store, and what documents are used in connection with this flow? 2. What documents are prepared when merchandise is sold? 3. Does the store keep perpetual inventory records? If so, does it keep the records in units only, or does it keep track of cost as well? If not, what system does the store use? 4. How often does the company take a physical inventory? 5. How are financial statements generated for the store? 6. What method does the company use to cost its inventory for financial statements? LO1 LO4 Inventory Costing Methods and Ratios SO5 SO6 C 5. Refer to the note related to inventories in CVS Corporation’s annual report in the Supplement to Chapter 5 to answer the following questions: What inven- tory method(s) does CVS use? If LIFO inventories had been valued at FIFO, why would there be no difference? Do you think many of the company’s inven- tories are valued at market? Few companies use the retail method, so why do you think CVS uses it? Compute and compare the inventory turnover and days’ inventory on hand for CVS for 2008 and 2007. Ending 2006 inventories were $7,560.2 million. Chapter Assignments 389 LO1 Inventory Efficiency C 6. Refer to CVS’s annual report in the Supplement to Chapter 5 and to the

following data (in millions) for Walgreens: cost of goods sold, $42,391 and $38,518.1 for 2008 and 2007, respectively; inventories, $7,249, $6,790, $6,050 for 2008, 2007, and 2006, respectively. Ending inventories for 2006 for CVS were $7,560.2 million. Calculate inventory turnover and days’ inventory on hand for 2007 and 2008. If you did C 5, refer to your answer there for CVS. Has either company improved its performance over the past two years? What advantage does the superior com- pany’s performance provide to it? Which company appears to make the most efficient use of inventories? Explain your answers. C H A P T E R 9 Cash and Receivables C ash and receivables require careful oversight to ensure that Making a Statement they are ethically handled. If cash is mismanaged or stolen, it can bring about the downfall of a business. Because accounts INCOME STATEMENT receivable and notes receivable require estimates of future losses, Revenues they can be easily manipulated to show improvement in reported – Expenses earnings. Improved earnings can, of course, enhance a company’s = Net Income stock price, as well as the bonuses of its executives. In this chapter, we address the management of cash and demonstrate the impor- STATEMENT OF tance of estimates in accounting for receivables. OWNER’S EQUITY Beginning Balance + Net Income LEARNING OBJECTIVES – Withdrawals LO1 Identify and explain the management and ethical issues = Ending Balance related to cash and receivables. (pp. 392–399) BALANCE SHEET LO2 Define cash equivalents, and explain methods of controlling Assets Liabilities cash, including bank reconciliations. (pp. 399–403) LO3 Apply the allowance method of accounting for uncollectible Owner’s Equity accounts. (pp. 403–411) A = L + OE LO4 Define promissory note, and make common calculations for promissory notes receivable. (pp. 411–415) STATEMENT OF CASH FLOWS Operating activities + Investing activities + Financing activities = Change in Cash + Beginning Balance = Ending Cash Balance Estimation of uncollectible credit sales affects the amount of accounts receivable on the balance sheet and operating expenses on the income statement. 390 DECISION POINT (cid:2) A USER’S FOCUS (cid:2) How can Pente Computer Company manage its cash PENTE COMPUTER COMPANY needs? (cid:2) How can the company reduce Pente Computer Company sells computer products for cash or the level of uncollectible on credit. The company’s peak sales occur in August and Septem- accounts and increase the likelihood that accounts ber, when students are shopping for computers and computer- receivable will be paid on time? related supplies, and during the pre-holiday season in November and D ecember. It is now January, and Andre Pente, the company’s (cid:2) How can the company evaluate the effectiveness of its credit owner, has been reviewing the company’s performance over the policies and the level of its past two years. He has determined that in those years, approximately accounts receivable? 1.5 p ercent of net sales have been uncollectible, and he is concerned that this year, the company may not have enough cash to cover operations before sales begin to increase again in late summer. In this chapter, we discuss concepts and techniques that would help Pente manage his cash and accounts receivable so that the company maintains its liquidity by answering the questions at the right. 391 392 CHAPTER 9 Cash and Receivables Management The management of cash and accounts and notes receivable is critical to main- taining adequate liquidity. These assets are important components of the operat- Issues Related ing cycle, which also includes inventories and accounts payable. In dealing with to Cash and cash and receivables, management must address five key issues: managing cash Receivables needs, setting credit policies, evaluating the level of accounts receivable, financing receivables, and making ethical estimates of credit losses. LO1 Identify and explain the management and ethical issues Cash Management related to cash and receivables. On the balance sheet, cash usually consists of currency and coins on hand, checks

and money orders from customers, and deposits in checking and savings accounts. Cash is the most liquid of all assets and the most readily available to pay debts. It is central to the operating cycle because all operating transactions eventually use or generate cash. Cash may include a compensating balance, an amount that is not entirely free to be spent. A compensating balance is a minimum amount that a bank requires a company to keep in its bank account as part of a credit-granting arrangement. Such an arrangement restricts cash; in effect, it increases the interest on the loan and reduces a company’s liquidity. The Securities and Exchange Commission therefore requires companies that have compensating balances to disclose the amounts involved. Most companies experience seasonal cycles of business activity during the year. During some periods, sales are weak; during others, they are strong. There are also periods when expenditures are high, and periods when they are low. For toy companies, college textbook publishers, amusement parks, construction com- panies, and manufacturers of sports equipment, the cycles are dramatic, but all companies experience them to some degree. Seasonal cycles require careful planning of cash inflows, cash outflows, bor- rowing, and investing. Figure 9-1 shows the seasonal cycles typical of an athletic sportswear company like Nike. As you can see, cash receipts from sales are high- est in the late spring and summer because that is when most people engage in outdoor sports. Sales are relatively low in the winter months. On the other hand, cash expenditures are highest in late winter and spring as the company builds up inventory for spring and summer selling. During the late summer, fall, and FOCUS ON BUSINESS PRACTICE How Do Good Companies Deal with Bad Times? Good companies manage their cash well even in bad times. DaimlerChrysler—were awash in cash. However, in little When a slump in the technology market caused Texas over a year, the three companies went through $28 b illion in Instrument’s sales to decline by more than 40 percent, cash through various purchases, losses, dividends, and share resulting in a loss of nearly $120 million, this large electron- buybacks. Then, with increasing losses from rising costs, big ics firm actually increased its cash by acting quickly to cut rebates, and zero percent financing, they were suddenly faced its purchases of plant assets by two-thirds. It also reduced with a shortage of cash. As a result, Standard & Poor’s lowered its payroll and lowered the average number of days it had their credit ratings, which raises the interest cost of borrowing inventory on hand from 71 to 58.1 money. Perhaps the Big Three should have held on to some of In similar circumstances, some companies have not reacted that cash.2 By 2009, GM and DaimlerChrysler were bankrupt as quickly as Texas Instruments. For example, before 9/11, and needed huge government bailouts in order to survive the Big Three automakers—General Motors, Ford, and and emerge again as viable companies. Management Issues Related to Cash and Receivables 393 FIGURE 9-1 Cash balance Seasonal Cycles and Cash Cash expenditures Requirements for an Athletic $ (000s) Cash receipts Sportswear Company 150 100 50 Cash for investing 0 Need for borrowing –50 Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. winter, the company has excess cash on hand that it needs to invest in a way that will earn a return but still permit access to cash as needed. During spring and early summer, the company needs to plan for short-term borrowing to tide it over until cash receipts pick up later in the year. Accounts Receivable and Credit Policies Like cash, accounts receivable and notes receivable are major types of short- term financial assets. Both kinds of receivables result from extending credit to individual customers or to other companies. Retailers like Sears (now merged with Kmart) have made credit available to nearly every responsible person in the United States. Every field of retail trade has expanded by allowing customers to

make payments a month or more after the date of sale. What is not so apparent is that credit has expanded even more among wholesalers and manufacturers like Nike than at the retail level. Figure 9-2 shows the levels of accounts receivable in selected industries. As we have indicated, accounts receivable are the short-term financial assets of a wholesaler or retailer that arise from sales on credit. This type of credit is often called trade credit. Terms of trade credit usually range from 5 to 60 days, depending on industry practice. For some companies that sell to consumers, installment accounts receivable, which allow the buyer to make a series of time payments, constitute a significant portion of accounts receivable. Department stores, appliance stores, furniture stores, used car dealers, and other retail busi- nesses often offer installment credit. The installment accounts receivable of retail- ers like Sears and JCPenney can amount to millions of dollars. Although the 394 CHAPTER 9 Cash and Receivables FIGURE 9-2 Accounts Receivable as a Percentage Advertising 49.0% of Total Assets for Selected Industries Interstate 33.4% Trucking Auto and 18.3% Home Supply Grocery 5.9% Stores Machinery 21.6% Computers 26.1% 0 5 10 15 20 25 30 35 40 45 50 Service Industries Merchandising Industries Manufacturing Industries Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006. payment period may be 24 months or more, installment accounts receivable are classified as current assets if such credit policies are customary in the industry. On the balance sheet, accounts receivable designates amounts arising from credit sales made to customers in the ordinary course of business. Because loans or credit sales made to employees, officers, or owners of the corporation increase the risk of uncollectibility and conflict of interest, they appear separately on the balance sheet under asset titles like receivables from employees. Normally, individual accounts receivable have debit balances, but sometimes customers overpay their accounts either by mistake or in anticipation of making future purchases. When these accounts show credit balances, the company should show the total credits on its balance sheet as a current liability. The reason for this is that if the customers make no future purchases, the company will have to grant them refunds. Companies that sell on credit do so to be competitive and to increase sales. In setting credit terms, a company must keep in mind the credit terms of its compet- itors and the needs of its customers. Obviously, any company that sells on credit wants customers who will pay their bills on time. To increase the likelihood of selling only to customers who will pay on time, most companies develop control procedures and maintain a credit department. The credit department’s respon- sibilities include examining each person or company that applies for credit and approving or rejecting a credit sale to that customer. Typically, the credit depart- ment asks for information about the customer’s financial resources and debts. It may also check personal references and credit bureaus for further information. Then, based on the information it has gathered, it decides whether to extend credit to the customer. Companies that are too lenient in granting credit can run into difficulties when customers don’t pay. For example, Sprint, one of the weaker companies in the highly competitive cell phone industry, targeted customers with poor credit histories. It attracted so many who failed to pay their bills that its stock dropped by 50 percent, to $2.50, because of the losses that resulted.3 Evaluating the Level of Accounts Receivable Two common measures of the effect of a company’s credit policies are receivable turnover and days’ sales uncollected. The receivable turnover shows how many times, on average, a company turned its receivables into cash during an account- ing period. It reflects the relative size of a company’s accounts receivable and the success of its credit and collection policies. It may also be affected by external

factors, such as seasonal conditions and interest rates. Days’ sales uncollected is Management Issues Related to Cash and Receivables 395 a related measure that shows, on average, how long it takes to collect accounts receivable. The receivable turnover is computed by dividing net sales by average accounts receivable (net of allowances). Theoretically, the numerator should be net credit sales, but the amount of net credit sales is rarely available in public reports, so investors use total net sales. Using data from Nike’s annual report, we can com- pute the company’s receivable turnover in 2009 as follows (dollar amounts are in millions): Receivable Turnover (cid:2) _ ________ N__e_t _S_a_le_s_ ________ Average Accounts Receivable (cid:2) ________$ _ _1 _9 _,1 __7 _6 _. _1 _ _______ ($2,883.9 (cid:3) $2,795.3) (cid:5) 2 (cid:2) _$ _1 _9 _, _1 _7 _6 __.1 _ (cid:2) 6.8 Times $2,839.6 FIGURE 9-3 Times Receivable Turnover for Selected Advertising 8.0 Industries Interstate 9.9 Trucking Auto and 16.2 Home Supply Grocery 84.7 Stores Machinery 7.9 Computers 6.2 0 2 4 6 8 10 12 14 16 18 100 Service Industries Merchandising Industries Manufacturing Industries Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006. To find days’ sales uncollected, the number of days in the accounting period, in this case a year, is divided by the receivable turnover, as follows: Days’ Sales Uncollected (cid:2) _____3 __6 _5 _ D _ _a _y _s _ ____ (cid:2) _3 _6 _5 _ _D __ay _s _ (cid:2) 53.7 Days Receivable Turnover 6.8 Times FIGURE 9-4 Days Days’ Sales Uncollected for Advertising 45.6 Selected Industries Interstate 36.9 Trucking Auto and 22.5 Home Supply Grocery 4.3 Stores Machinery 46.2 Computers 58.9 0 5 10 15 20 25 30 35 40 45 50 55 60 Service Industries Merchandising Industries Manufacturing Industries Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006. 396 CHAPTER 9 Cash and Receivables Thus, Nike turned its receivables 6.8 times a year, or an average of every 53.7 days. Study Note A turnover period of this length is not unusual among apparel companies because their credit terms allow retail outlets time to sell products before paying for them. For many businesses with When the days’ sales uncollected is added to the days’ inventory on hand of seasonal sales activity, such as Nordstrom, Dillard’s, Marshall 83.0 days computed in Chapter 8, Nike must provide financing for a total of Field’s, and Macy’s, the fourth 136.7 days (83.0 (cid:3) 53.7) or more than four months. quarter produces more than As Figure 9-3 shows, the receivable turnover ratio varies substantially from 25 percent of annual sales. For industry to industry. Because grocery stores have few receivables, they have a these businesses, receivables very quick turnover. The turnover in interstate trucking is 10.7 times because are highest at the balance sheet the typical credit terms in that industry are 30 days. The turnover in the machin- date, resulting in an artificially ery and computer industries is lower because those industries tend to have lon- low receivable turnover and ger credit terms. high days’ sales uncollected. Figure 9-4 shows the days’ sales uncollected for the industries listed in Figure 9-3. Grocery stores, which have the lowest ratio (4.0 days) require the least amount of receivables financing; the computer industry, with days’ sales uncollected of 58.9 days, requires the most. Financing Receivables Financial flexibility is important to most companies. Companies that have sig- nificant amounts of assets tied up in accounts receivable may be unwilling or unable to wait until they collect cash from their receivables. Many corporations have set up finance companies to help their customers pay for the purchase of their products. For example, Ford has set up Ford Motor Credit Com- pany (FMCC) and Sears has set up Sears Roebuck Acceptance Corporation (SRAC). Other companies borrow funds by pledging their accounts receivable as collateral. If a company does not pay back its loan, the creditor can take the

collateral (in this case, the accounts receivable) and convert it to cash to satisfy the loan. Companies can also raise funds by selling or transferring accounts receiv- Study Note able to another entity, called a factor, as illustrated in Figure 9-5. The sale or transfer of accounts receivable, called factoring, can be done with or without A company that factors its receivables will have a better recourse. With recourse means that the seller of the receivables is liable to the receivable turnover and days’ factor (i.e., the purchaser) if a receivable cannot be collected. Without recourse sales uncollected than a means that the factor bears any losses from unpaid accounts. A company’s company that does not factor acceptance of credit cards like Visa, MasterCard, or American Express is an them. example of factoring without recourse because the issuers of the cards accept the risk of nonpayment. The factor, of course, charges a fee for its service. The fee for sales with recourse is usually about 2 percent of the accounts receivable. The fee is higher FIGURE 9-5 1 How Factoring Works Makes sale on COMPANY credit $1,000 BUYER Returns Sells receivable Advances $130 5 for $980 2 $850 reserve Pays 4 without 3 $1,000 recourse FACTOR Note: Factor will keep $130 reserve if buyer does not pay. Management Issues Related to Cash and Receivables 397 FOCUS ON BUSINESS PRACTICE How Do Powerful Buyers Cause Problems for Small Suppliers? Big buyers often have significant power over small suppli- deals they make until it is too late. When Earthly Elements, ers, and their cash management decisions can cause severe Inc., accepted a $10,000 order for dried floral gifts from a cash flow problems for the little companies that depend on national home shopping network, its management was them. For instance, in an effort to control costs and optimize ecstatic because the deal increased sales by 25 percent. But cash flow, Ameritech Corp. told 70,000 suppliers that it in four months, the resulting cash crunch forced the com- would begin paying its bills in 45 days instead of 30. Other pany to close down. When the shopping network finally large companies routinely take 90 days or more to pay. paid for the order six months later, it was too late to revive Some small suppliers are so anxious to get the big compa- Earthly Elements.4 nies’ business that they fail to realize the implications of the for sales without recourse because the factor’s risk is greater. In accounting ter- minology, a seller of receivables with recourse is said to be contingently liable. A contingent liability is a potential liability that can develop into a real liability if a particular event occurs. In this case, the event would be a customer’s nonpayment of a receivable. A contingent liability generally requires disclosure in the notes to the financial statements. Another way for a company to generate cash from its receivables is through a process called securitization. Under securitization, a company groups its receiv- ables in batches and sells them at a discount to companies and investors. When the receivables are paid, the buyers get the full amount; their profit depends on the amount of the discount. Circuit City tried to avoid bankruptcy by selling all its receivables without recourse, which means that after selling them, it had no further liability, even if no customers were to pay. If Circuit City sold its receiv- ables with recourse and a customer did not pay, it would have had to make good on the debt.5 However, by selling without recourse, it had to accept a lower price for its receivables. This strategy did not prevent it from going bankrupt. A form of securitization that has caused huge problems in the real estate mar- ket in recent years is subprime loans (home loans to individuals with poor credit ratings and low incomes). These loans are batched together and sold in units. Although subprime loans (home loans to individuals with poor credit ratings and low incomes) represent only a small portion of the mortgage loan market, they

have caused huge problems in the real estate market in recent years. These loans are a form of securitization in that they are batched together and sold in units as safe investments, when in fact they are quite risky. As just one of many examples, when people by the thousands were unable to keep up with their mortgage pay- ments, the investments were marked down to their fair value. This loss of value led to the demise of such venerable firms as Lehman Brothers, the sale of Merrill Lynch, and ultimately to a massive government bailout.6 Another method of financing receivables is to sell promissory notes, held as notes receivable, to a financial lender, usually a bank. This practice is called dis- counting because the bank derives its profit by deducting the interest from the maturity value of the note. The holder of the note (usually the payee) endorses the note and turns it over to the bank. The bank expects to collect the maturity value of the note (principal plus interest) on the maturity date, but it also has recourse against the note’s endorser. 398 CHAPTER 9 Cash and Receivables For example, if Company X holds a $20,000 note from Company Z and the note will pay $1,200 in interest, a bank may be willing to buy the note for $19,200. If Company Z pays, the bank will receive $21,200 at maturity and realize a $2,000 profit. If it fails to pay, Company X is liable to the bank for pay- ment. In the meantime, Company X has a contingent liability in the amount of the discounted note plus interest that it must disclose in the notes to its financial statements. Ethics and Estimates in Accounting for Receivables As we have noted, companies extend credit to customers because they expect it will increase their sales and earnings, but they know they will always have some credit customers who cannot or will not pay. The accounts of such customers are called uncollectible accounts, or bad debts, and they are expenses of selling on credit. To match these expenses, or losses, to the revenues they help generate, they should be recognized at the time credit sales are made. Of course, at the time a company makes credit sales, it cannot identify which customers will not pay their bills, nor can it predict the exact amount of money it will lose. Therefore, to adhere to the matching rule, it must estimate losses from uncollectible accounts. The estimate becomes an expense in the fiscal year in which the sales are made. Because the amount of uncollectible accounts can only be estimated and the exact amount will not be known until later, a company’s earnings can be easily manipulated. Earnings can be overstated by underestimating the amount of losses from uncollectible accounts, and they can be understated by overestimating the amount of the losses. Misstatements of earnings can occur simply because of a bad estimate. But, as we have noted elsewhere, they can be deliberately made to meet analysts’ estimates of earnings, reduce income taxes, or meet benchmarks for bonuses. Among the many examples of unethical or questionable practices in dealing with uncollectible accounts are the following: (cid:2) WorldCom (now MCI) increased revenues and hid losses by continuing to bill customers for service for years after the customers had quit paying. (cid:2) The policy of Household International, a large personal finance company, seems to be flexible about when to declare loans delinquent. As a result, the company can vary its estimates of uncollectible accounts from year to year.7 (cid:2) By making large allowances for estimated uncollectible accounts and then gradually reducing them, Bank One improved its earnings over several years.8 (cid:2) HealthSouth manipulated its income by varying its estimates of the differ- ence between what it charged patients and what it could collect from insur- ance companies.9 Companies with high ethical standards try to be accurate in their estimates of uncollectible accounts, and they disclose the basis of their estimates. For example, Nike’s management describes its estimates as follows:

We make ongoing estimates relating to the collectibility of our accounts receivables and maintain an allowance for estimated losses resulting from the inability of our customers to make required payments. In determin- ing the amount of the allowance, we consider our historical level of credit losses and make judgments about the creditworthiness of significant cus- tomers based on ongoing credit evaluations. Since we cannot predict future changes in the financial stability of our customers, actual future losses from uncollectible accounts may differ from our estimates.10 Cash Equivalents and Cash Control 399 STOP & APPLY Santorini Company has cash of $20,000, net accounts receivable of $60,000, and net sales of $500,000. Last year’s net accounts receivable were $40,000. Compute the following ratios: receivable turnover and days’ sales uncollected. SOLUTION Receivable Turnover (cid:2) _________ N __e_t _S_a_l_es_ _ ________ Average Accounts Receivable $500,000 (cid:2) ($60,000 (cid:3) $40,000)(cid:5)2 $500,000 (cid:2) _ ________ (cid:2) 10.0 Times $50,000 365 Days 365 Days Days’ Sales Uncollected (cid:2) _ ______ ___ ____ ____ (cid:2) _ ________ (cid:2) 36.5 Days Receivable Turnover 10.0 Times Cash Equivalents Cash Equivalents and Cash Control As we noted earlier, cash is the asset most readily available to pay debts, but at times a company may have more cash on hand than it needs to pay its debts. LO2 Define cash equivalents, Excess cash should not remain idle, especially during periods of high interest rates. and explain methods of con- Management may decide to invest the excess cash in short-term interest-bearing trolling cash, including bank accounts or certificates of deposit (CDs) at banks and other financial institutions, reconciliations. in government securities (such as U.S. Treasury notes), or in other securities. If these investments have a term of 90 days or less when they are purchased, they are called cash equivalents because the funds revert to cash so quickly they are treated as cash on the balance sheet. Nike describes its treatment of cash and cash equivalents as follows: Cash and equivalents represent cash and short-term, highly liquid investments Study Note with maturities of three months or less at date of purchase. The carrying amounts reflected in the consolidated balance sheet for cash and equivalents The statement of cash approximate fair value.11 flows explains the change in the balance of cash and According to a recent survey of 600 large U.S. corporations, 6 percent use the cash equivalents from one term cash as the balance sheet caption, and 89 percent use either cash and cash accounting period to the next. equivalents or cash and equivalents. The rest either combine cash with marketable securities or have no cash.12 Fair Value of Cash and Cash Equivalents Cash and cash equivalents are financial instruments that are valued at fair value. In most cases, the amount recorded in the records approximates fair value, and most businesses and other entities consider cash equivalents to be very safe invest- ments. Companies often invest these funds in money market funds to earn interest with cash when they don’t need cash for current operations. Money market funds usually invest in very safe securities, such as commercial paper, which is short- term debt of other entities. Although money market funds are not guaranteed, 400 CHAPTER 9 Cash and Receivables investors do not expect losses on these investments. However, in recent years a few of these funds invested in batches of subprime mortgages in an attempt to earn a little higher interest rate. The result has been traumatic for all parties. Bank of America, for instance, shut down its $34 billion Columbia Strategic Cash Portfolio money market fund when investors pulled out $21 billion because the fund was losing so much money from investing in subprime loans.13 Cash Control Methods In an earlier chapter, we discussed the concept of internal control and how it applies to cash transactions. Here, we address three additional ways of controlling

cash: imprest systems; banking services, including electronic funds transfer; and bank reconciliations. Imprest Systems Most companies need to keep some currency and coins on hand. Currency and coins are needed for cash registers, for paying expenses that are impractical to pay by check, and for situations that require cash advances—for example, when sales representatives need cash for travel expenses. One way to control a cash fund and cash advances is by using an imprest system. A common form of imprest system is a petty cash fund, which is established at a fixed amount. A receipt documents each cash payment made from the fund. The fund is periodically reimbursed, based on the documented expenditures, by the exact amount necessary to restore its original cash balance. The person responsible for the petty cash fund must always be able to account for its contents by showing that total cash and receipts equal the original fixed amount. Banking Services All businesses rely on banks to control cash receipts and cash disbursements. Banks serve as safe depositories for cash, negotiable instruments, and other valuable business documents, such as stocks and bonds. The checking accounts that banks provide improve control by minimizing the amount of cur- rency a company needs to keep on hand and by supplying permanent records of all cash payments. Banks also serve as agents in a variety of transactions, such as the collection and payment of certain kinds of debts and the exchange of foreign currencies. Electronic funds transfer (EFT) is a method of conducting business trans- Study Note actions that does not involve the actual transfer of cash. With EFT, a company Periodically, banks detect electronically transfers cash from its bank to another company’s bank. For the individuals who are kiting. banks, the electronic transfer is simply a bookkeeping entry. Companies today Kiting is the illegal issuing of rely heavily on this method of payment. Wal-Mart, for example, makes 75 per- checks when there is insufficient cent of its payments to suppliers through EFT. money to cover them. Before Because of EFT and other electronic banking services, we are rapidly becom- one kited check clears the bank, ing a cashless society. Automated teller machines (ATMs) allow bank customers a kited check from another to make deposits, withdraw cash, transfer funds among accounts, and pay bills. account is deposited to cover it, Large consumer banks like Citibank, Chase, and Bank of America process hun- making an endless circle. dreds of thousands of ATM transactions each week. Many banks also give cus- tomers the option of paying bills online, over the telephone, and with debit cards. In 2007, debit cards accounted for more than 1 trillion transactions.14 When a customer makes a retail purchase using a debit card, the amount of the purchase is deducted directly from the buyer’s bank account. The bank usually documents debit card transactions for the retailer, but the retailer must develop new internal controls to ensure that the transactions are recorded properly and that unauthor- ized transfers do not occur. It is expected that within a few years, a majority of all retail activity will be handled electronically. Cash Equivalents and Cash Control 401 Bank Reconciliations RRarely does the balance of a company’s Cash account exactly equal the cash bal- Study Note aance on its bank statement. The bank may not yet have recorded certain transac- The ending balance on a ttions that appear in the company’s records, and the company may not yet have company’s bank statement does rrecorded certain bank transactions. A bank reconciliation is therefore a necessary not represent the amount of sstep in internal control. A bank reconciliation is the process of accounting for cash that should appear on its tthe difference between the balance on a company’s bank statement and the bal- balance sheet. At the balance aance in its Cash account. This process involves making additions to and subtrac- sheet date, deposits may be in ttions from both balances to arrive at the adjusted cash balance.

transit to the bank, and some The following are the transactions that most commonly appear in a com- checks may be outstanding. ppany’s records but not on its bank statement: That is why companies must 1. Outstanding checks: These are checks that a company has issued and recorded prepare a bank reconciliation. but that do not yet appear on its bank statement. 2. Deposits in transit: These are deposits a company has sent to its bank but that the bank did not receive in time to enter on the bank statement. Transactions that may appear on the bank statement but not in the company’s records include the following: 1. Service charges (SC): Banks often charge a fee, or service charge, for the use of a checking account. Many banks base the service charge on a number of factors, such as the average balance of the account during the month or the number of checks drawn. 2. NSF (nonsufficient funds) checks: An NSF check is a check that a company has deposited but that is not paid when the bank presents it to the issuer’s bank. The bank charges the company’s account and returns the check so that the company can try to collect the amount due. If the bank has deducted the NSF check on the bank statement but the company has not deducted it from its book balance, an adjustment must be made in the bank reconciliation. The company usually reclassifies the NSF check from Cash to Accounts Receivable because it must now collect from the person or company that wrote the check. 3. Miscellaneous debits and credits: Banks also charge for other services, such as Study Note stopping payment on checks and printing checks. The bank notifies the deposi- tor of each deduction by including a debit memorandum with the monthly A credit memorandum means statement. A bank also sometimes serves as an agent in collecting on promis- that an amount was added to the bank balance; a debit sory notes for the depositor. When it does, it includes a credit memorandum in memorandum means that an the bank statement, along with a debit memorandum for the service charge. amount was deducted. 4. Interest income: Banks commonly pay interest on a company’s average bal- ance. Accounts that pay interest are sometimes called NOW or money market accounts. An error by either the bank or the depositor will, of course, require immediate correction. To illustrate the preparation of a bank reconciliation, suppose that Terry Ser- vices Company’s bank statement for August shows a balance of $1,735.53 on August 31 and that on the same date, the company’s records show a cash bal- ance of $1,207.95. The purpose of a bank reconciliation is to identify the items that make up the difference between these amounts and to determine the correct cash balance. Exhibit 9-1 shows Terry Services Company’s bank reconciliation for August. The circled numbers in the exhibit refer to the following: 1. The bank has not recorded a deposit in the amount of $138.00 that the com- pany mailed to the bank on August 31. 402 CHAPTER 9 Cash and Receivables 2. The bank has not paid the five checks that the company issued in July and Study Note August: Even though the July 14 check was deducted in the July 30 recon- Bank reconciliations perform ciliation, it must be deducted again in each subsequent month in which it an important function in remains outstanding. internal control. If carried out 3. The company incorrectly recorded a $150 deposit from cash sales as $165.00. by someone who does not have On August 6, the bank received the deposit and corrected the amount. access to the bank account, they provide an independent check 4. Among the returned checks was a credit memorandum showing that the bank on the person or persons who had collected a promissory note from K. Diaz in the amount of $140.00, plus do have that access. $10.00 in interest on the note. A debit memorandum was also enclosed for the $2.50 collection fee. The company had not entered these amounts in its records. 5. Also returned with the bank statement was an NSF check for $64.07 that the company had received from a customer named Austin Chase. The NSF check

was not reflected in the company’s records. 6. A debit memorandum was enclosed for the regular monthly service charge of $6.25. The company had not yet recorded this charge. 7. Interest earned on the company’s average balance was $7.81. As you can see in Exhibit 9-1, starting from their separate balances, both the bank and book amounts are adjusted to the amount of $1,277.94. This adjusted EXHIBIT 9-1 Terry Services Company Bank Reconciliation Bank Reconciliation August 31, 2011 Balance per bank, August 31 $ 1,735.53 1 Add deposit of August 31 in transit 138.00 $ 1,873.53 2 Less outstanding checks: No. 551, issued on July 14 $ 75.00 No. 576, issued on Aug. 30 20.34 No. 578, issued on Aug. 31 250.00 No. 579, issued on Aug. 31 185.00 No. 580, issued on Aug. 31 65.25 595.59 Adjusted bank balance, August 31 $1,277.94 Balance per books, August 31 $ 1,207.95 Add: 4 Note receivable collected by bank $140.00 4 Interest income on note 10.00 7 Interest income 7.81 157.81 $ 1,365.76 Study Note Less: 3 Overstatement of deposit of August 6 $ 15.00 It is possible to place an item 4 Collection fee 2.50 in the wrong section of a bank 5 NSF check of Austin Chase 64.07 reconciliation and still have it balance. The correct adjusted 6 Service charge 6.25 87.82 balance must be obtained. Adjusted book balance, August 31 $1,277.94 Uncollectible Accounts 403 balance is the amount of cash the company owns on August 31 and thus is the amount that should appear on its August 31 balance sheet. When outstanding checks are presented to the bank for payment and the bank receives and records the deposit in transit, the bank balance will automati- cally become correct. However, the company must update its book balance by recording all the items reported by the bank. Thus, Terry Services Company would record an increase (debit) in Cash with the following items: (cid:2) Decrease (credit) in Notes Receivable, $140.00 (cid:2) Increase (credit) in Interest Income, $10.00 (interest on note) (cid:2) Increase (credit) in Interest Income, $7.81 (interest on average bank balance) The company would record a reduction (credit) in Cash with these items: (cid:2) Decrease (debit) in Sales, $15.00 (error in recording deposit) (cid:2) Increase (debit) in Accounts Receivable, $64.07 (return of NSF check) (cid:2) Increase (debit) in Bank Service Charges, $8.75 ($6.25 (cid:3) $2.50) As the use of electronic funds transfer, automatic payments, and debit cards increases, the items that most businesses will have to deal with in their bank rec- onciliations will undoubtedly grow. STOP & APPLY At year end, Sunjin Company had currency and coins in cash registers of $1,100, money orders from customers of $2,000, deposits in checking accounts of $12,000, U.S. Treasury bills due in 80 days of $50,000, certificates of deposit at the bank that mature in six months of $200,000, and U.S. Treasury bonds due in one year of $100,000. Calculate the amount of cash and cash equivalents that will be shown on the company’s year-end balance sheet. SOLUTION Currency and coins $ 1,100 Money orders 2,000 Checking accounts 12,000 U.S.Treasury bills (due in 80 days) 50,000 Cash and Cash equivalents $65,100 The certificates of deposit and U.S. Treasury Bonds mature in more than 90 days and thus are not cash equivalents. Uncollectible Some companies recognize a loss at the time they determine that an account is uncollectible by reducing Accounts Receivable and increasing Uncollectible Accounts Accounts Expense. Federal regulations require companies to use this method of recognizing a loss—called the direct charge-off method—in computing taxable LO3 Apply the allowance income. Although small companies may use this method for all purposes, com- method of accounting for panies that follow generally accepted accounting principles do not use it in their uncollectible accounts. financial statements. The reason they do not is that a direct charge-off is usually recorded in a different accounting period from the one in which the sale takes place, and the method therefore does not conform to the matching rule. Compa-

nies that follow GAAP use the allowance method. 404 CHAPTER 9 Cash and Receivables The Allowance Method Under the allowance method, losses from bad debts are matched against the sales Study Note they help to produce. As mentioned earlier, when management extends credit The allowance method relies to increase sales, it knows it will incur some losses from uncollectible accounts. on an estimate of uncollectible Losses from credit sales should be recognized at the time the sales are made so accounts, but unlike the direct that they are matched to the revenues they help generate. Of course, at the time charge-off method, it is in a company makes credit sales, management cannot identify which customers will accord with the matching rule. not pay their debts, nor can it predict the exact amount of money the com- pany will lose. Therefore, to observe the matching rule, losses from uncollectible accounts must be estimated, and the estimate becomes an expense in the period in which the sales are made. For example, suppose that Sharon Sales Company made most of its sales on credit during its first year of operation, 2011. At the end of the year, accounts receivable amounted to $200,000. On December 31, 2011, management reviewed the collectible status of the accounts receivable. Approximately $12,000 of the $200,000 of accounts receivable were estimated to be uncollectible. The following adjusting entry would be made on December 31 of that year: Assets (cid:2) Liabilities (cid:3) Owner’s Equity ALLOWANCE FOR UNCOLLECTIBLE UNCOLLECTIBLE ACCOUNTS ACCOUNTS EXPENSE Dr. Cr. Dr. Cr. Dec. 31 12,000 Dec. 31 12,000 Entry in Journal Form: Dr. Cr. A (cid:3) L (cid:4) OE Dec. 31 Uncollectible Accounts Expense 12,000 (cid:4)12,000 (cid:4)12,000 Allowance for Uncollectible Accounts 12,000 To record the estimated uncollectible accounts expense for the year Disclosure of Uncollectible Accounts Uncollectible Accounts Expense appears on the income statement as an operating Study Note expense. Allowance for Uncollectible Accounts appears on the balance sheet Allowance for Uncollectible as a contra account that is deducted from accounts receivable. It reduces the Accounts reduces the gross accounts receivable to the amount expected to be collected in cash, as follows: accounts receivable to the Current assets: amount estimated to be Cash $ 20,000 collectible (net realizable value). The purpose of another Short-term investments 30,000 contra account, Accumulated Accounts receivable $200,000 Depreciation, is not to reduce Less allowance for uncollectible accounts 12,000 188,000 the gross plant and equipment accounts to realizable value. Inventory 112,000 Rather, its purpose is to show Total current assets $350,000 how much of the cost of the plant and equipment has been Accounts receivable may also be shown on the balance sheet as follows: allocated as an expense to Accounts receivable (net of allowance for previous accounting periods. uncollectible accounts of $12,000) $188,000 Uncollectible Accounts 405 Or accounts receivable may be shown at “net,” with the amount of the allow- Study Note ance for uncollectible accounts identified in a note to the financial statements. For most companies, the “net” amount of accounts receivable approximates The allowance account is fair value. Fair value disclosures are not required for accounts receivable but necessary because the specific uncollectible accounts will not 341 of 600 large companies made this disclosure voluntarily. Of those, 325, be identified until later. or 95 percent, indicated that the net accounts receivable approximated fair value.15 The allowance account often has other titles, such as Allowance for Doubt- ful Accounts and Allowance for Bad Debts. Once in a while, the older phrase Reserve for Bad Debts will be seen, but in modern practice it should not be used. Bad Debts Expense is a title often used for Uncollectible Accounts Expense. Estimating Uncollectible Accounts Expense As noted, expected losses from uncollectible accounts must be estimated. Of Study Note course, estimates can vary widely. If management takes an optimistic view and

projects a small loss from uncollectible accounts, the resulting net accounts receiv- The accountant looks at both local and national economic able will be larger than if management takes a pessimistic view. The net income conditions in determining will also be larger under the optimistic view because the estimated expense will the estimated uncollectible be smaller. The company’s accountant makes an estimate based on past experi- accounts expense. ence and current economic conditions. For example, losses from uncollectible accounts are normally expected to be greater in a recession than during a period of economic growth. The final decision, made by management, on the amount of the expense will depend on objective information, such as the accountant’s analy- ses, and on certain qualitative factors, such as how investors, bankers, creditors, and others view the performance of the debtor company. Regardless of the quali- tative considerations, the estimated losses from uncollectible accounts should be realistic. Two common methods of estimating uncollectible accounts expense are the percentage of net sales method and the accounts receivable aging method. Percentage of Net Sales Method The percentage of net sales method asks the question, How much of this year’s net sales will not be collected? The answer determines the amount of uncollectible accounts expense for the year. FOCUS ON BUSINESS PRACTICE Cash Collections Can Be Hard to Estimate Companies must not only sell goods and services; they estimates of allowances for uncollectible accounts—actions must also generate cash flows by collecting on those sales. that eliminated previously reported earnings and caused When there are changes in the economy, some companies the companies’ stock prices to fall.16 However, it turned make big mistakes in estimating the amount of accounts out that these companies had overestimated how bad the they will collect. For example, when the dot-com bubble losses would be. In later years, they reduced their allow- burst in the early 2000s, companies like Nortel Networks, ances for credit losses, thereby increasing their reported Cisco Systems, and Lucent Technologies increased their earnings.17 406 CHAPTER 9 Cash and Receivables FFor example, the following balances represent Shivar Company’s ending figures Study Note ffor 2012: Unlike the direct charge-off method, the percentage of net SALES SALES RETURNS AND ALLOWANCES sales method matches revenues Dr. Cr. Dr. Cr. with expenses. Dec. 31 322,500 Dec. 31 20,000 SALES DISCOUNTS ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS Dr. Cr. Dr. Cr. Dec. 31 2,500 Dec. 31 1,800 The following are Shivar’s actual losses from uncollectible accounts for the past three years: Losses from Year Net Sales Uncollectible Accounts Percentage 2009 $260,000 $ 5,100 1.96 2010 297,500 6,950 2.34 2011 292,500 4,950 1.69 Total $850,000 $17,000 2.00 Credit sales often constitute most of a company’s sales. If a company has sub- stantial cash sales, it should use only its net credit sales in estimating uncollectible accounts. Shivar’s management believes that its uncollectible accounts will con- tinue to average about 2 percent of net sales. The uncollectible accounts expense for the year 2012 is therefore estimated as follows: 0.02 (cid:6) ($322,500 (cid:4) $20,000 (cid:4) $2,500) (cid:2) 0.02 (cid:6) $300,000 (cid:2) $6,000 The following entry would be made to record the estimate: Assets (cid:2) Liabilities (cid:3) Owner’s Equity ALLOWANCE FOR UNCOLLECTIBLE UNCOLLECTIBLE ACCOUNTS ACCOUNTS EXPENSE Dr. Cr. Dr. Cr. Dec. 31 1,800 Dec. 31 6,000 31 6,000 Bal. 7,800 Entry in Journal Form: Dr. Cr. A (cid:3) L (cid:4) OE Dec. 31 Uncollectible Accounts Expense 6,000 (cid:4)6,000 (cid:4)6,000 Allowance for Uncollectible Accounts 6,000 To record uncollectible accounts expense at 2 percent of $300,000 net sales Note that the Allowance for Uncollectible Accounts now has a balance of $7,800. The balance consists of the $6,000 estimated uncollectible accounts receivable from 2012 sales and the $1,800 estimated uncollectible accounts receivable from

previous years. Uncollectible Accounts 407 AAccounts Receivable Aging Method The accounts receivable aging Study Note mmethod asks the question, How much of the ending balance of accounts An aging of accounts receivable rreceivable will not be collected? With this method, the ending balance of is an important tool in cash AAllowance for Uncollectible Accounts is determined directly through an management because it helps aanalysis of accounts receivable. The difference between the amount deter- to determine what amounts mmined to be uncollectible and the actual balance of Allowance for Uncollect- are likely to be collected in the iible Accounts is the expense for the period. In theory, this method should months ahead. pproduce the same result as the percentage of net sales method, but in practice iit rarely does. The aging of accounts receivable is the process of listing each customer’s receivable account according to the due date of the account. If the customer’s account is past due, there is a possibility that the account will not be paid. And that possibility increases as the account extends further beyond the due date. The aging of accounts receivable helps management evaluate its credit and collection policies and alerts it to possible problems. Exhibit 9-2 illustrates the aging of accounts receivable for Gomez Com- pany. Each account receivable is classified as being not yet due or as being 1–30 days, 31–60 days, 61–90 days, or over 90 days past due. Based on past expe- rience, the estimated percentage for each category is determined and multiplied by the amount in each category to determine the estimated, or target, balance of Allowance for Uncollectible Accounts. In total, it is estimated that $4,918 of the $88,800 in accounts receivable will not be collected. Once the target balance for Allowance for Uncollectible Accounts has been found, it is necessary to determine the amount of the adjustment. The amount depends on the current balance of the allowance account. Let us assume two cases for the December 31 balance of Gomez Company’s Allowance for Uncol- lectible Accounts: (1) a credit balance of $1,600 and (2) a debit balance of $1,600. EXHIBIT 9-2 Analysis of Accounts Receivable by Age Gomez Company Analysis of Accounts Receivable by Age December 31, 2011 1–30 31–60 61–90 Over Not Days Days Days 90 Days Customer Total Yet Due Past Due Past Due Past Due Past Due K. Wu $ 300 $ 300 R. List 800 $ 800 B. Smith 2,000 $ 1,800 200 T. Vigo 500 $ 500 Others 85,200 42,000 28,000 7,600 4,400 $3,200 Totals $88,800 $43,800 $28,500 $8,400 $4,900 $3,200 Estimated percentage uncollectible 1.0 2.0 10.0 30.0 50.0 Allowance for Uncollectible Accounts $ 4,918 $ 438 $ 570 $ 840 $1,470 $1,600 408 CHAPTER 9 Cash and Receivables In the first case, an adjustment of $3,318 is needed to bring the balance of the allowance account to a $4,918 credit balance: Targeted balance for allowance for uncollectible accounts $4,918 Less current credit balance of allowance for uncollectible accounts 1,600 Uncollectible accounts expense $3,318 The uncollectible accounts expense is recorded as follows: Assets (cid:2) Liabilities (cid:3) Owner’s Equity ALLOWANCE FOR UNCOLLECTIBLE UNCOLLECTIBLE ACCOUNTS ACCOUNTS EXPENSE Dr. Cr. Dr. Cr. Dec. 31 1,600 Dec. 31 3,318 31 3,318 Bal. 4,918 Entry in Journal Form: Dr. Cr. A (cid:3) L (cid:4) OE Dec. 31 Uncollectible Accounts Expense 3,318 (cid:4)3,318 (cid:4)3,318 Allowance for Uncollectible Accounts 3,318 To bring the allowance for uncollectible accounts to the level of estimated losses Note that the resulting balance of Allowance for Uncollectible Accounts is $4,918. In the second case, because Allowance for Uncollectible Accounts has a debit Study Note balance of $1,600, the estimated uncollectible accounts expense for the year will When the write-offs in an have to be $6,518 to reach the targeted balance of $4,918. This calculation is as accounting period exceed the follows: amount of the allowance, a Targeted balance for allowance for uncollectible accounts $ 4,918 debit balance in the Allowance

for Uncollectible Accounts Plus current debit balance of allowance for uncollectible accounts 1,600 account results. Uncollectible accounts expense $6,518 The uncollectible accounts expense is recorded as follows: Assets (cid:2) Liabilities (cid:3) Owner’s Equity ALLOWANCE FOR UNCOLLECTIBLE UNCOLLECTIBLE ACCOUNTS ACCOUNTS EXPENSE Dr. Cr. Dr. Cr. Dec. 31 1,600 Dec. 31 6,518 Dec. 31 6,518 Bal. 4,918 Entry in Journal Form: Dr. Cr. A (cid:3) L (cid:4) OE Dec. 31 Uncollectible Accounts Expense 6,518 (cid:4)6,518 (cid:4)6,518 Allowance for Uncollectible Accounts 6,518 To bring the allowance for uncollectible accounts to the level of estimated losses Note that after this entry, Allowance for Uncollectible Accounts has a credit balance of $4,918. Uncollectible Accounts 409 Comparison of the Two Methods Both the percentage of net sales method Study Note and the accounts receivable aging method estimate the uncollectible accounts Describing the aging method expense in accordance with the matching rule, but as shown in Figure 9-6, they as the balance sheet method do so in different ways. The percentage of net sales method is an income state- emphasizes that the computation ment approach. It assumes that a certain proportion of sales will not be col- is based on ending accounts lected, and this proportion is the amount of Uncollectible Accounts Expense for receivable rather than on net the accounting period. The accounts receivable aging method is a balance sheet sales for the period. approach. It assumes that a certain proportion of accounts receivable outstand- ing will not be collected. This proportion is the targeted balance of the Allowance for Uncollectible Accounts account. The expense for the accounting period is the difference between the targeted balance and the current balance of the allowance account. Writing Off Uncollectible Accounts Regardless of the method used to estimate uncollectible accounts, the total of accounts receivable written off in an accounting period will rarely equal the esti- mated uncollectible amount. The allowance account will show a credit balance when the total of accounts written off is less than the estimated uncollectible Study Note amount. It will show a debit balance when the total of accounts written off is greater than the estimated uncollectible amount. When writing off an individual When it becomes clear that a specific account receivable will not be col- account, debit Allowance for Uncollectible Accounts, not lected, the amount should be written off to Allowance for Uncollectible Uncollectible Accounts Expense. Accounts. Remember that the uncollectible amount was already accounted for as an expense when the allowance was established. For example, assume that FIGURE 9-6 INCOME STATEMENT APPROACH: Two Methods of Estimating PERCENTAGE OF NET SALES METHOD Uncollectible Accounts UNCOLLECTIBLE Apply a percentage NET SALES ACCOUNTS to determine EXPENSE BALANCE SHEET APPROACH: ACCOUNTS RECEIVABLE AGING METHOD TARGETED BALANCE OF ACCOUNTS Apply a percentage ALLOWANCE FOR RECEIVABLE to determine UNCOLLECTIBLE ACCOUNTS* * *Add current debit balance or subtract current credit balance to determine uncollectible accounts expense. 410 CHAPTER 9 Cash and Receivables on January 15, 2012, T. Vigo, who owes Gomez Company $500, is declared bankrupt by a federal court. The entry to write off this account is as follows: Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity ACCOUNTS RECEIVABLE , T. VIGO Dr. Cr. Jan. 15 500 ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS Dr. Cr. Jan. 15 500 Entry in Journal Form: Dr. Cr. A (cid:3) L (cid:4) OE Jan. 15 Allowance for Uncollectible Accounts 500 (cid:3)500 Accounts Receivable, T. Vigo 500 (cid:4)500 Write-off of account Although the write-off removes the uncollectible amount from Accounts Receiv- able, it does not affect the estimated net realizable value of accounts receivable. It simply reduces T. Vigo’s account to zero and reduces Allowance for Uncollect- ible Accounts by $500, as shown below: Balances Balances Before After Write-off Write-off

Accounts receivable $88,800 $88,300 Less allowance for uncollectible accounts 4,918 4,418 Estimated net realizable value of accounts receivable $83,882 $83,882 Occasionally, a customer whose account has been written off as uncollectible will later be able to pay some or all of the amount owed. When that happens, two entries must be made: one to reverse the earlier write-off (which is now incorrect) and another to show the collection of the account. STOP & APPLY Jazz Instruments Co., sells its merchandise on credit. In the company’s last fiscal year, which ended July 31, it had net sales of $7,000,000. At the end of the fiscal year, it had Accounts Receivable of $1,800,000 and a credit balance in Allowance for Uncollectible Accounts of $11,200. In the past, the company has been unable to collect on approximately 1 percent of its net sales. An aging analysis of accounts receivable has indicated that $80,000 of current receivables is uncollectible. 1. C alculate the amount of uncollectible 2. How would your answers change if accounts expense, and use T accounts to Allowance for Uncollectible Accounts had determine the resulting balance of Allow- a debit balance of $11,200 instead of a ance for Uncollectible Accounts under the credit balance? percentage of net sales method and the accounts receivable aging method. (continued) Notes Receivable 411 SOLUTION 1. Percentage of net sales method: ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS Dr. Cr. July 31 11,200 31 UA Exp. 70,000* July 31 Bal. 81,200 *Uncollectible Accounts Expense (cid:2) $7,000,000 (cid:6) 0.01 Aging Method: ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS Dr. Cr. July 31 11,200 31 UA Exp. 68,800* July 31 Bal. 80,000 *Uncollectible Accounts Expense (cid:2) $80,000 (cid:4) $11,200 2. Under the percentage of net sales method, the amount of the expense is the same in 1 and 2 but the ending bal- ance will be $58,800 ($70,000 (cid:4) $11,200). Under the accounts receivable aging method, the ending balance is the same, but the amount of the expense will be $91,200 ($80,000 (cid:3) $11,200). Notes Receivable A promissory note is an unconditional promise to pay a definite sum of money on demand or at a future date. The person or company that signs the note and thereby promises to pay is the maker of the note. The entity to whom payment is LO4 Define promissory note, to be made is the payee. and make common calculations The promissory note shown in Figure 9-7 is an unconditional promise by for promissory notes receivable. the maker, Samuel Mason, to pay a definite sum—or principal ($1,000)—to the payee, Cook County Bank & Trust, on August 18, 2011. As you can see, this promissory note is dated May 20, 2011 and bears an interest rate of 8 percent. A payee includes all the promissory notes it holds that are due in less than Study Note one year in notes receivable in the current assets section of its balance sheet. A Notes receivable and notes maker includes them in notes payable in the current liabilities section of its bal- payable are distinguished ance sheet. Since notes receivable and notes payable are financial instruments, from accounts receivable and companies may voluntarily disclose their fair value. In most cases, fair value accounts payable because the approximates the amount in the account records, but sometimes the adjust- latter were not created by a ments to fair value are significant, such as in the recent cases of subprime loans formal promissory note. gone bad. The nature of a company’s business generally determines how frequently it receives promissory notes from customers. Firms that sell durable goods of high value, such as farm machinery and automobiles, often accept promissory notes. Among the advantages of these notes are that they produce interest income and represent a stronger legal claim against a debtor than do accounts receivable. In addition, selling—or discounting—promissory notes to banks is a common financing method. Almost all companies occasionally accept promissory notes, and many companies obtain them in settlement of past-due accounts.

412 CHAPTER 9 Cash and Receivables FIGURE 9-7 A Promissory Note PROMISSORY NOTE $1,000.00 May 20, 2011 Interest period starts Amount Date Principal For value received, I promise to pay to the order of Cook County Bank & Trust Payee Chicago, Illinois One thousand and no/100 — — — — — Dollars Interest period ends on the maturity date August 18, 2011 on plus interest at the annual rate of 8 percent. Interest rate Maker Maturity Date The maturity date is the date on which a promissory note must be paid. This date must be stated on the note or be determinable from the facts stated on the note. The following are among the most common statements of maturity date: 1. A specific date, such as “November 14, 2011” 2. A specific number of months after the date of the note, such as “three months after November 14, 2011” 3. A specific number of days after the date of the note, such as “60 days after November 14, 2011” The maturity date is obvious when a specific date is stated. And when the maturity date is a number of months from the date of the note, one simply uses the same day in the appropriate future month. For example, a note dated January 20 that is due in two months would be due on March 20. When the maturity date is a specific number of days from the date of the note, however, the exact maturity date must be determined. In computing the maturity date, it is important to exclude the date of the note. For example, a note dated May 20 and due in 90 days would be due on August 18, determined as follows: Days remaining in May (31(cid:4)20) 11 Days in June 30 Days in July 31 Days in August 18 Total days 90 Notes Receivable 413 Automobile manufacturers like Toyota, whose assembly line is pictured here, often accept promis- sory notes, which are unconditional promises to pay a definite sum of money on demand or at a future date. These notes produce interest income and represent a stronger legal claim against a debtor than do accounts receivable. In addition, firms com- monly raise money by selling—or discounting—promissory notes to banks. Courtesy of Ricardo Azoury/ iStockphoto.com. Duration of a Note Study Note The duration of a note is the time between a promissory note’s issue date and Another way to compute the its maturity date. Knowing the exact number of days in the duration of a note is duration of notes is to begin important because interest is calculated on that basis. Identifying the duration is with the interest period, as in easy when the maturity date is stated as a specific number of days from the date this example: of the note because the two numbers are the same. However, when the maturity Interest period 90 days remaining in date is stated as a specific date, the exact number of days must be determined. (cid:4)11 May (31 (cid:4) 20) Assume that a note issued on May 10 matures on August 10. The duration of the 79 note is 92 days: (cid:4)30 days in June Days remaining in May (31(cid:4)10) 21 49 (cid:4)31 days in July Days in June 30 18 due date in August Days in July 31 Days in August 10 Total days 92 Interest and Interest Rate Interest is the cost of borrowing money or the return on lending money, depend- ing on whether one is the borrower or the lender. The amount of interest is based on three factors: the principal (the amount of money borrowed or lent), the rate of interest, and the loan’s length of time. The formula used in computing interest is as follows: Principal (cid:6) Rate of Interest (cid:6) Time (cid:2) Interest 414 CHAPTER 9 Cash and Receivables Interest rates are usually stated on an annual basis. For example, the interest on a one-year, 8 percent, $1,000 note would be $80 ($1,000 (cid:6) 8/100 (cid:6) 1 (cid:2) $80). If the term, or time period, of the note is three months instead of a year, the interest charge would be $20 ($1,000 (cid:6) 8/100 (cid:6) 3/12 (cid:2) $20). When the term of a note is expressed in days, the exact number of days must be used in computing the interest. Thus, if the term of the note described above was 45 days, the interest would be $9.86, computed as follows: $1,000 (cid:6) 8/100

(cid:6) 45/365 (cid:2) $9.86. Maturity Value The maturity value is the total proceeds of a promissory note—face value plus interest—at the maturity date. The maturity value of a 90-day, 8 percent, $1,000 note is computed as follows: Maturity Value (cid:2) Principal (cid:3) Interest (cid:2) $1,000 (cid:3) ($1,000 (cid:6) 8/100 (cid:6) 90/365) (cid:2) $1,000 (cid:3) $19.73 (cid:2) $1,019.73 There are also so-called non-interest-bearing notes. The maturity value is the face value, or principal amount. In this case, the principal includes an implied interest cost. Accrued Interest A promissory note received in one accounting period may not be due until a later period. The interest on a note accrues by a small amount each day of the note’s duration. As we described in an earlier chapter, the matching rule requires that the accrued interest be apportioned to the periods in which it belongs. For example, assume that the $1,000, 90-day, 8 percent note discussed above was received on August 31 and that the fiscal year ended on September 30. In this case, 30 days interest, or $6.58 ($1,000 (cid:6) 8/100 (cid:6) 30/365 (cid:2) $6.58), would be earned in the fiscal year that ends on September 30. An adjusting entry would be made to record the interest receivable as an asset and the interest income as revenue. The remainder of the interest income, $13.15 ($1,000 (cid:6) 8/100 (cid:6) 60/365), would be recorded as income, and the interest receivable ($6.58) would be shown as received when the note is paid. Note that all the cash for the interest is received when the note is paid, but the interest income is apportioned to two fiscal years. Dishonored Note When the maker of a note does not pay the note at maturity, it is said to be a dis- honored note. The holder, or payee, of a dishonored note should make an entry to transfer the total amount due (including interest income) from Notes Receiv- able to an account receivable from the debtor. Two objectives are accomplished by transferring a dishonored note into an Accounts Receivable account. First, it leaves only notes that have not matured and are presumably negotiable and col- lectible in the Notes Receivable account. Second, it establishes a record in the borrower’s accounts receivable account that the customer has dishonored a note receivable. Such information may be helpful in deciding whether to extend credit to the customer in the future. Pente Computer Company: Review Problem 415 STOP & APPLY Assume that on December 1, 2011, a company receives a 90-day, 8 percent, $5,000 note and that the company prepares financial statements monthly. 1. What is the maturity date of the note? 4. I f the company’s fiscal year ends on 2. H ow much interest will be earned on the December 31, describe the adjusting entry note if it is paid when due? that would be made, including the amount. 5. H ow much interest will be earned on this 3. What is the maturity value of the note? note in 2012? SOLUTION 1. Maturity date is March 1, 2012, determined as follows: Days remaining in December (31(cid:4)1) 30 Days in January 31 Days in February 28 Days in March 1 Total days 90 2. Interest: $5,000 (cid:6) 8/100 (cid:6) 90/365 (cid:2) $98.63 3. Maturity value: $5,000 (cid:6) $98.63 (cid:2) $5,098.63 4. An adjusting entry to accrue 30 days of interest income in the amount of $32.88 ($5,000 (cid:6) 8/100 (cid:6) 30/365) would be needed. 5. Interest earned in 2012: $65.75 ($98.63 (cid:4) $32.88) (cid:2) PENTE COMPUTER COMPANY: REVIEW PROBLEM In this chapter’s Decision Point, we posed the following questions: • How can Pente Computer Company manage its cash needs? • How can the company reduce the level of uncollectible accounts and increase the likelihood that accounts receivable will be paid on time? • How can the company evaluate the effectiveness of its credit policies and the level of its accounts receivable? During the months when sales are at their peak, Pente Computer Company may have excess cash available that it can invest in a way that earns a return but still permits ready access to cash. At other times, it may have to arrange for short-term borrowing. To ensure

that it can borrow funds when it needs to, the company must maintain good relations with its bank. Aging and Net Sales To reduce the level of its uncollectible accounts and increase the likelihood that Method Contrasted and accounts receivable will be paid on time, Pente should set credit policies and have a credit department that administers the policies when screening customers who are Receivables Ratios applying for credit. LO1 LO3 416 CHAPTER 9 Cash and Receivables To evaluate the effectiveness of the company’s credit policies and the level of its accounts receivable, management can compare the current year’s receivable turnover and days’ sales uncollected with those ratios in previous years. The following data (in thousands) are from Pente’s records for 2009 and 2010. Use these data to complete the requirements below. 2010 2009 Cash $ 100 $ 300 Accounts receivable 800 650 Allowance for doubtful (42) (30) accounts Net sales 2,400 1,800 Required 1. Compute Uncollectible Accounts Expense for 2010, and determine the ending balance of Allowance for Uncollectible Accounts and Accounts Receivable, Net, under (a) the percentage of net sales method and (b) the accounts receivable aging method, assuming year-end uncollectible accounts to be $76,000. 2. Compute the receivable turnover and days’ sales uncollected using the data from the accounts receivable aging method in requirement 1 and assuming that the prior year’s net accounts receivable were $706,000. 3. User insight: Why do the two methods in requirement 1 produce different results? What are the implications of the result in requirement 2? Answers to 1. Uncollectible Accounts Expense and ending account balances Review Problem a. Percentage of net sales method: Uncollectible Accounts Expense (cid:2) 1.5 percent (cid:6) $2,400,000 (cid:2) $36,000 Allowance for Uncollectible Accounts (cid:2) $36,000 + $42,000 (cid:2) $78,000 Accounts Receivable, Net (cid:2) $800,000 (cid:4) $78,000 (cid:2) $722,000 b. Accounts receivable aging method: Uncollectible Accounts Expense (cid:2) $76,000 (cid:4) $30,000 (cid:2) $46,000 Allowance for Uncollectible Accounts (cid:2) $76,000 Accounts Receivable, Net (cid:2) $800,000 (cid:4) $76,000 (cid:2) $724,000 2. Receivable turnover and days’ sales uncollected Receivable Turnover(cid:2) Average AN cce ot u S na tle s s Receivable (cid:2) ($724,00$ 02 (cid:3),40 $0 6,0 20 00 ,000) (cid:5) 2 $2,400,000 (cid:2) $672,000 (cid:2)3.6 times 365 days 365 days Days’ Sales Uncollected (cid:2) (cid:2) (cid:2)101.4 days Receivable Turnover 3.6 times 3. Both methods are estimates and thus are likely to give different results. Ideally, the results are similar. It takes Pente 101.4 days on average to collect its sales. This is almost four months, which means the company must manage its cash and borrowings carefully or revise its credit terms. Stop & Review 417 STOP & REVIEW LO1 Identify and explain the The management of cash and receivables is critical to maintaining adequate management and ethical liquidity. In dealing with these assets, management must (1) consider the need issues related to cash for short-term investing and borrowing as the business’s balance of cash fluctu- and receivables. ates during seasonal cycles, (2) establish credit policies that balance the need for sales with the ability to collect, (3) evaluate the level of receivables using receiv- able turnover and days’ sales uncollected, (4) assess the need to increase cash flows through the financing of receivables, and (5) understand the importance of ethics in estimating credit losses. LO2 Defi ne cash equivalents, Cash equivalents are investments that have a term of 90 days or less. Cash and and explain methods of cash equivalents are financial instruments that are valued at fair value. Methods controlling cash, includ- of controlling cash include imprest systems; banking services, including elec- ing bank reconciliations. tronic funds transfer; and bank reconciliations. A bank reconciliation accounts for the difference between the balance on a company’s bank statement and the

balance in its Cash account. It involves adjusting for outstanding checks, depos- its in transit, service charges, NSF checks, miscellaneous debits and credits, and interest income. LO3 Apply the allowance Because of the time lag between credit sales and the time accounts are judged method of accounting for uncollectible, the allowance method is used to match the amount of uncollectible uncollectible accounts. accounts against revenues in any given period. Uncollectible accounts expense is estimated by using either the percentage of net sales method or the accounts receivable aging method. When the first method is used, bad debts are judged to be a certain percentage of sales during the period. When the second method is used, certain percentages are applied to groups of accounts receivable that have been arranged by due dates. Allowance for Uncollectible Accounts is a contra-asset account to Accounts Receivable. The estimate of uncollectible accounts is debited to Uncollectible Accounts Expense and credited to the allowance account. When an individual account is determined to be uncollectible, it is removed from Accounts Receiv- able by debiting the allowance account and crediting Accounts Receivable. If the written-off account is later collected, the earlier entry is reversed and the collec- tion is recorded in the normal way. LO4 Defi ne promissory note, A promissory note is an unconditional promise to pay a definite sum of money and make common cal- on demand or at a future date. Companies that sell durable goods of high value, culations for promissory such as farm machinery and automobiles, often accept promissory notes. Selling notes receivable. these notes to banks is a common financing method. In accounting for promis- sory notes, it is important to know how to calculate the maturity date, duration of a note, interest and interest rate, and maturity value. 418 CHAPTER 9 Cash and Receivables REVIEW of Concepts and Terminology The following concepts and terms Contingent liability 397 (LO1) Maturity value 414 (LO4) were introduced in this chapter: Direct charge-off method 403 (LO3) Notes payable 411 (LO4) Accounts receivable 393 (LO1) Discounting 397 (LO1) Notes receivable 411 (LO4) Accounts receivable aging method Dishonored note 414 (LO4) Percentage of net sales method 407 (LO3) Duration of a note 414 (LO4) 405 (LO3) Aging of accounts receivable Electronic funds transfer (EFT) Promissory note 411 (LO4) 407 (LO3) 400 (LO2) Securitization 397 (LO1) Allowance for Uncollectible Factor 396 (LO1) Short-term financial assets 393 (LO1) Accounts 404 (LO3) Factoring 396 (LO1) Trade credit 393 (LO1) Allowance method 404 (LO3) Imprest system 400 (LO2) Uncollectible accounts 398 (LO1) Bank reconciliation 401 (LO2) Installment accounts receivable Cash 392 (LO1) 393 (LO1) Key Ratios Cash equivalents 399 (LO2) Interest 413 (LO4) Days’ sales uncollected 394 (LO1) Compensating balance 392 (LO1) Maturity date 412 (LO4) Receivable turnover 394 (LO1) Chapter Assignments 419 CHAPTER ASSIGNMENTS BUILDING Your Basic Knowledge and Skills Short Exercises LO1 Management Issues SE 1. Indicate whether each of the following actions is related to (a) managing cash needs, (b) setting credit policies, (c) financing receivables, or (d) ethically reporting receivables: 1. Selling accounts receivable to a factor 2. Borrowing funds for short-term needs during slow periods 3. Conducting thorough checks of new customers’ ability to pay 4. Making every effort to reflect possible future losses accurately LO1 Short-Term Liquidity Ratios SE 2. Graff Company has cash of $40,000, net accounts receivable of $90,000, and net sales of $720,000. Last year’s net accounts receivable were $70,000. Compute the following ratios: (a) receivable turnover and (b) days’ sales uncol- lected. LO2 Cash and Cash Equivalents SE 3. Compute the amount of cash and cash equivalents on Car Wash Company’s balance sheet if, on the balance sheet date, it has currency and coins on hand of $125, deposits in checking accounts of $750, U.S. Treasury bills due in

80 days of $7,500, and U.S. Treasury bonds due in 200 days of $12,500. LO2 Bank Reconciliation SE 4. Prepare a bank reconciliation from the following information: a. Balance per bank statement as of June 30, $4,862.77 b. Balance per books as of June 30, $2,479.48 c. Deposits in transit, $654.24 d. Outstanding checks, $3,028.89 e. Interest on average balance, $8.64 LO3 Percentage of Net Sales Method SE 5. At the end of October, Zion Company’s management estimates the uncollectible accounts expense to be 1 percent of net sales of $1,500,000. Prepare the entry to record the uncollectible accounts expense, assuming the Allowance for Uncollectible Accounts has a debit balance of $7,000. LO3 Accounts Receivable Aging Method SE 6. An aging analysis on June 30 of the accounts receivable of Sung Corpora- tion indicates that uncollectible accounts amount to $86,000. Prepare the entry to record uncollectible accounts expense under each of the following indepen- dent assumptions: a. Allowance for Uncollectible Accounts has a credit balance of $18,000 before adjustment. b. Allowance for Uncollectible Accounts has a debit balance of $14,000 before adjustment. 420 CHAPTER 9 Cash and Receivables LO3 Write-off of Accounts Receivable SE 7. Windy Corporation, which uses the allowance method, has accounts receiv- able of $50,800 and an allowance for uncollectible accounts of $9,800. An account receivable from Tom Novak of $4,400 is deemed to be uncollectible and is written off. What is the amount of net accounts receivable before and after the write-off? LO4 Notes Receivable Calculations SE 8. On August 25, Champion Company received a 90-day, 9 percent note in settlement of an account receivable in the amount of $20,000. Determine the maturity date, amount of interest on the note, and maturity value. Exercises LO1 LO2 Discussion Questions E 1. Develop a brief answer to each of the following questions: 1. Name some businesses whose needs for cash fluctuate during the year. Name some whose needs for cash are relatively stable over the year. 2. Why is it advantageous for a company to finance its receivables? 3. To increase its sales, a company decides to increase its credit terms from 15 to 30 days. What effect will this change in policy have on receivable turn- over and days’ sales uncollected? 4. How might the receivable turnover and days’ sales uncollected reveal that management is consistently underestimating the amount of losses from uncollectible accounts? Is this action ethical? LO3 LO4 Discussion Questions E 2. Develop a brief answer to each of the following questions: 1. What accounting rule is violated by the direct charge-off method of recog- nizing uncollectible accounts? Why? 2. In what ways is Allowance for Uncollectible Accounts similar to Accumu- lated Depreciation? In what ways is it different? 3. Under what circumstances would an accrual of interest income on an interest-bearing note receivable not be required at the end of an accounting period? LO1 Management Issues E 3. Indicate whether each of the following actions is primarily related to (a) managing cash needs, (b) setting credit policies, (c) financing receivables, or (d) ethically reporting accounts receivable: 1. Buying a U.S. Treasury bill with cash that is not needed for a few months 2. Comparing receivable turnovers for two years 3. Setting a policy that allows customers to buy on credit 4. Selling notes receivable to a financing company 5. Making careful estimates of losses from uncollectible accounts 6. Borrowing funds for short-term needs in a period when sales are low 7. Changing the terms for credit sales in an effort to reduce the days’ sales uncollected 8. Revising estimated credit losses in a timely manner when conditions change 9. Establishing a department whose responsibility is to approve customers’ credit Chapter Assignments 421 LO1 Short-Term Liquidity Ratios E 4. Using the following data from Lopez Corporation’s financial statements, compute the receivable turnover and the days’ sales uncollected: Current assets Cash $ 35,000 Short-term investments 85,000

Notes receivable 120,000 Accounts receivable, net 200,000 Inventory 250,000 Prepaid assets 25,000 Total current assets $ 715,000 Current liabilities Notes payable $ 300,000 Accounts payable 75,000 Accrued liabilities 10,000 Total current liabilities $ 385,000 Net sales $1,600,000 Last year’s accounts receivable, net $ 180,000 LO2 Cash and Cash Equivalents E 5. At year end, Lam Company had currency and coins in cash registers of $2,800, money orders from customers of $5,000, deposits in checking accounts of $32,000, U.S. Treasury bills due in 80 days of $90,000, certificates of deposit at the bank that mature in six months of $100,000, and U.S. Treasury bonds due in one year of $50,000. Calculate the amount of cash and cash equivalents that will be shown on the company’s year-end balance sheet. LO2 Bank Reconciliation E 6. Prepare a bank reconciliation from the following information: a. Balance per bank statement as of May 31, $17,755.44 b. Balance per books as of May 31, $12,211.94 c. Deposits in transit, $2,254.81 d. Outstanding checks, $7,818.16 e. Bank service charge, $19.85 LO3 Percentage of Net Sales Method E 7. At the end of the year, Emil Enterprises estimates the uncollectible accounts expense to be 0.8 percent of net sales of $7,575,000. The current credit balance of Allowance for Uncollectible Accounts is $12,900. Prepare the entry to record the uncollectible accounts expense. What is the balance of Allowance for Uncol- lectible Accounts after this adjustment? LO3 Accounts Receivable Aging Method E 8. The Accounts Receivable account of Samson Company shows a debit balance of $52,000 at the end of the year. An aging analysis of the individual accounts indicates estimated uncollectible accounts to be $3,350. Prepare the entry to record the uncollectible accounts expense under each of the following independent assumptions: (a) Allowance for Uncollectible Accounts has a credit balance of $400 before adjustment, and (b) Allowance for Uncollect- ible Accounts has a debit balance of $400 before adjustment. What is the balance of Allowance for Uncollectible Accounts after each of these adjustments? 422 CHAPTER 9 Cash and Receivables LO3 Aging Method and Net Sales Method Contrasted E 9. At the beginning of 2011, the balances for Accounts Receivable and Allowance for Uncollectible Accounts were $430,000 and $31,400 (credit), respectively. During the year, credit sales were $3,200,000 and collections on account were $2,950,000. In addition, $35,000 in uncollectible accounts was written off. Using T accounts, determine the year-end balances of Accounts Receivable and Allowance for Uncollectible Accounts. Then prepare the year-end adjusting entry to record the uncollectible accounts expense under each of the following conditions. Also show the year-end balance sheet presentation of accounts receiv- able and allowance for uncollectible accounts. a. Management estimates the percentage of uncollectible credit sales to be 1.4 percent of total credit sales. b. Based on an aging of accounts receivable, management estimates the end-of- year uncollectible accounts receivable to be $38,700. Post the results of each of the entries to the T account for Allowance for Uncollectible Accounts. LO3 Aging Method and Net Sales Method Contrasted E 10. During 2010, Omega Company had net sales of $11,400,000. Most of the sales were on credit. At the end of 2010, the balance of Accounts Receivable was $1,400,000 and Allowance for Uncollectible Accounts had a debit balance of $48,000. Omega Company’s management uses two methods of estimating uncol- lectible accounts expense: the percentage of net sales method and the accounts receivable aging method. The percentage of uncollectible sales is 1.5 percent of net sales, and based on an aging of accounts receivable, the end-of-year uncollect- ible accounts total $140,000. Prepare the end-of-year adjusting entry to record the uncollectible accounts expense under each method. What will the balance of Allowance for Uncollect- ible Accounts be after each adjustment? Why are the results different? Which

method is likely to be more reliable? Why? LO3 Aging Method and Net Sales Method Contrasted E 11. The First Fence Company sells merchandise on credit. During the fiscal year ended July 31, the company had net sales of $1,150,000. At the end of the year, it had Accounts Receivable of $300,000 and a debit balance in Allowance for Uncollectible Accounts of $1,700. In the past, approximately 1.4 percent of net sales have proved to be uncollectible. Also, an aging analysis of accounts receivable reveals that $15,000 of the receivables appears to be uncollectible. Prepare entries in journal form to record uncollectible accounts expense using (a) the percentage of net sales method and (b) the accounts receivable aging method. What is the resulting balance of Allowance for Uncollectible Accounts under each method? How would your answers under each method change if Allowance for Uncollectible Accounts had a credit balance of $1,700 instead of a debit balance? Why do the methods result in different balances? LO3 Write-off of Accounts Receivable E 12. Colby Company, which uses the allowance method, has Accounts Receiv- able of $65,000 and an allowance for uncollectible accounts of $6,400 (credit). The company sold merchandise to Irma Hegerman for $7,200 and later received $2,400 from Hegerman. The rest of the amount due from Hegerman had to be written off as uncollectible. Using T accounts, show the beginning balances and Chapter Assignments 423 the effects of the Hegerman transactions on Accounts Receivable and Allowance for Uncollectible Accounts. What is the amount of net accounts receivable before and after the write-off? LO4 Interest Computations E 13. Determine the interest on the following notes: a. $77,520 at 10 percent for 90 days b. $54,400 at 12 percent for 60 days c. $61,200 at 9 percent for 30 days d. $102,000 at 15 percent for 120 days e. $36,720 at 6 percent for 60 days LO4 Notes Receivable Calculations E 14. Determine the maturity date, interest at maturity, and maturity value for a 90-day, 10 percent, $36,000 note from Archer Corporation dated February 15. LO4 Notes Receivable Calculations E 15. Determine the maturity date, interest in 2010 and 2011, and maturity value for a 90-day, 12 percent, $30,000 note from a customer dated December 1, 2010, assuming a December 31 year end. LO4 Notes Receivable Calculations E 16. Determine the maturity date, interest at maturity, and maturity value for each of the following notes: a. A 60-day, 10 percent, $4,800 note dated January 5 received from A. Gal for granting a time extension on a past-due account. b. A 60-day, 12 percent, $3,000 note dated March 9 received from T. Kawa for granting a time extension on a past-due account. Problems LO2 Bank Reconciliation P 1. The following information is available for Unique Globe, as of May 31, 2011: a. Cash on the books as of May 31 amounted to $43,784.16. Cash on the bank statement for the same date was $53,451.46. b. A deposit of $5,220.94, representing cash receipts of May 31, did not appear on the bank statement. c. Outstanding checks totaled $3,936.80. d. A check for $1,920.00 returned with the statement was recorded incorrectly in the check register as $1,380.00. The check was for a cash purchase of merchandise. e. The bank service charge for May amounted to $30. f. The bank collected $12,200.00 for Unique Globe, on a note. The face value of the note was $12,000.00. g. An NSF check for $178.56 from a customer, Eve Lay, was returned with the statement. h. The bank mistakenly charged to the company account a check for $750.00 drawn by another company. i. The bank reported that it had credited the account for $250.00 in interest on the average balance for May. 424 CHAPTER 9 Cash and Receivables Required 1. Prepare a bank reconciliation for Unique Globe, Inc., as of May 31, 2011. 2. Prepare the entries in journal form necessary to adjust the accounts. 3. What amount of cash should appear on Unique Globe’s balance sheet as of May 31? User insight (cid:2) 4. Why is a bank reconciliation considered an important control over cash?

LO1 LO3 Methods of Estimating Uncollectible Accounts and Receivables Analysis P 2. Moore Company had an Accounts Receivable balance of $640,000 and a credit balance in Allowance for Uncollectible Accounts of $33,400 at January 1, 2011. During the year, the company recorded the following transactions: a. Sales on account, $2,104,000 b. Sales returns and allowances by credit customers, $106,800 c. Collections from customers, $1,986,000 d. Worthless accounts written off, $39,600 The company’s past history indicates that 2.5 percent of its net credit sales will not be collected. Required 1. Prepare T accounts for Accounts Receivable and Allowance for Uncollect- ible Accounts. Enter the beginning balances, and show the effects on these accounts of the items listed above, summarizing the year’s activity. Deter- mine the ending balance of each account. 2. Compute Uncollectible Accounts Expense and determine the ending balance of Allowance for Uncollectible Accounts under (a) the percent- age of net sales method and (b) the accounts receivable aging method, assuming an aging of the accounts receivable shows that $48,000 may be uncollectible. 3. Compute the receivable turnover and days’ sales uncollected, using the data from the accounts receivable aging method in requirement 2. 4. How do you explain that the two methods used in requirement 2 result User insight (cid:2) in different amounts for Uncollectible Accounts Expense? What rationale underlies each method? LO3 Accounts Receivable Aging Method P 3. The Ciao Style Store uses the accounts receivable aging method to estimate uncollectible accounts. On February 1, 2010, the balance of the Accounts Receivable account was a debit of $442,341, and the balance of Allowance for Uncollectible Accounts was a credit of $43,700. During the year, the store had sales on account of $3,722,000, sales returns and allow- ances of $60,000, worthless accounts written off of $44,300, and collections from customers of $3,211,000. As part of the end-of-year (January 31, 2011) procedures, an aging analysis of accounts receivable is prepared. The analysis, which is partially complete, is as follows: 31–60 61–90 Over Customer Not Yet 1–30 Days Days Days 90 Days Account Total Due Past Due Past Due Past Due Past Due Balance Forward $793,791 $438,933 $149,614 $106,400 $57,442 $41,402 Chapter Assignments 425 To finish the analysis, the following accounts need to be classified: Account Amount Due Date J. Kras $11,077 Jan. 15 T. Lopez 9,314 Feb. 15 (next fiscal year) L. Zapal 8,664 Dec. 20 R. Caputo 780 Oct. 1 E. Rago 14,710 Jan. 4 S. Smith 6,316 Nov. 15 A. Quinn 4,389 Mar. 1 (next fiscal year) $55,250 From past experience, the company has found that the following rates are realistic for estimating uncollectible accounts: Percentage Considered Time Uncollectible Not yet due 2 1–30 days past due 5 31–60 days past due 15 61–90 days past due 25 Over 90 days past due 50 Required 1. Complete the aging analysis of accounts receivable. 2. Compute the end-of-year balances (before adjustments) of Accounts Receiv- able and Allowance for Uncollectible Accounts. 3. Prepare an analysis computing the estimated uncollectible accounts. 4. How much is Ciao Style Store’s estimated uncollectible accounts expense for the year? (Round the adjustment to the nearest whole dollar.) User insight (cid:2) 5. What role do estimates play in applying the aging analysis? What factors might affect these estimates? LO4 Notes Receivable Calculations P 4. Rich Importing Company engaged in the following transactions involving promissory notes: May 3 Sold engines to Kabel Company for $30,000 in exchange for a 90-day, 11 percent promissory note. 16 Sold engines to Vu Company for $16,000 in exchange for a 60-day, 12 percent note. 31 Sold engines to Vu Company for $15,000 in exchange for a 90-day, 10 percent note. Required 1. For each of the notes, determine the (a) maturity date, (b) interest on the note, and (c) maturity value. 2. Assume that the fiscal year for Rich Importing Company ends on June 30. How much interest income should be recorded on that date?

User insight (cid:2) 3. What are the effects of the transactions in May on cash flows for the year ended June 30? Alternate Problems LO2 Bank Reconciliation P 5. The following information is available for Prime Company as of April 30, 2011: a. Cash on the books as of April 30 amounted to $113,175.28. Cash on the bank statement for the same date was $140,717.08. 426 CHAPTER 9 Cash and Receivables b. A deposit of $14,349.84, representing cash receipts of April 30, did not appear on the bank statement. c. Outstanding checks totaled $7,302.64. d. A check for $2,420.00 returned with the statement was recorded as $2,024.00. The check was for advertising. e. The bank service charge for April amounted to $35.00. f. The bank collected $36,300.00 for Prime Company on a note. The face value of the note was $36,000.00 g. An NSF check for $1,140.00 from a customer, Tom Jones, was returned with the statement. h. The bank mistakenly deducted a check for $700.00 that was drawn by Tiger Corporation. i. The bank reported a credit of $560.00 for interest on the average balance. Required 1. Prepare a bank reconciliation for Prime Company as of April 30, 2011. 2. Prepare the necessary entries in journal form from the reconciliation. 3. State the amount of cash that should appear on Prime Company’s balance sheet as of April 30. User insight (cid:2) 4. Why is a bank reconciliation a necessary internal control? LO1 LO3 Methods of Estimating Uncollectible Accounts and Receivables Analysis P 6. On December 31 of last year, the balance sheet of Korab Company had Accounts Receivable of $149,000 and a credit balance in Allowance for Uncol- lectible Accounts of $10,150. During the current year, Korab Company’s records included the following selected activities: (a) sales on account, $597,500; (b) sales returns and allowances, $36,500; (c) collections from customers, $575,000; and (d) accounts written off as worthless, $8,000. In the past, 1.6 percent of Korab Company’s net sales have been uncollectible. Required 1. Prepare T accounts for Accounts Receivable and Allowance for Uncollect- ible Accounts. Enter the beginning balances, and show the effects on these accounts of the items listed above, summarizing the year’s activity. Deter- mine the ending balance of each account. 2. Compute Uncollectible Accounts Expense and determine the ending balance of Allowance for Uncollectible Accounts under (a) the percentage of net sales method and (b) the accounts receivable aging method. Assume that an aging of the accounts receivable shows that $10,000 may be uncollectible. 3. Compute the receivable turnover and days’ sales uncollected, using the data from the accounts receivable aging method in requirement 2. User insight (cid:2) 4. How do you explain that the two methods used in requirement 2 result in different amounts for Uncollectible Accounts Expense? What rationale underlies each method? LO3 Accounts Receivable Aging Method P 7. Garcia Company uses the accounts receivable aging method to estimate uncollectible accounts. At the beginning of the year, the balance of the Accounts Receivable account was a debit of $90,430, and the balance of Allowance for Uncollectible Accounts was a credit of $8,100. During the year, the company had sales on account of $475,000, sales returns and allowances of $6,200, worth- less accounts written off of $8,800, and collections from customers of $452,730. At the end of year (December 31, 2011), a junior accountant for Garcia Com- pany was preparing an aging analysis of accounts receivable. At the top of page 6 of the report, the following totals appeared: Chapter Assignments 427 31–60 61–90 Over 90 Customer Not Yet 1–30 Days Days Days Days Past Account Total Due Past Due Past Due Past Due Due Balance Forward $89,640 $49,030 $24,110 $9,210 $3,990 $3,300 To finish the analysis, the following accounts need to be classified: Account Amount Due Date B. Smith $ 930 Jan. 14 (next year) L. Wing 645 Dec. 24 A. Rak 1,850 Sept. 28 T. Cat 2,205 Aug. 16 M. Nut 350 Dec. 14 S. Prince 1,785 Jan. 23 (next year) J. Wind 295 Nov. 5 $8,060

From past experience, the company has found that the following rates are realistic for estimating uncollectible accounts: Time Percentage Considered Uncollectible Not yet due 2 1–30 days past due 5 31–60 days past due 15 61–90 days past due 25 Over 90 days past due 50 Required 1. Complete the aging analysis of accounts receivable. 2. Compute the end-of-year balances (before adjustments) of Accounts Receiv- able and Allowance for Uncollectible Accounts. 3. Prepare an analysis computing the estimated uncollectible accounts. 4. Calculate Garcia Company’s estimated uncollectible accounts expense for the year (round the amount to the nearest whole dollar). User insight (cid:2) 5. What role do estimates play in applying the aging analysis? What factors might affect these estimates? LO4 Notes Receivable Calculations P 8. Abraham Importing Company engaged in the following transactions involving promissory notes: May 3 Sold engines to Anton Company for $60,000 in exchange for a 90-day, 12 percent promissory note. 16 S old engines to Yu Company for $32,000 in exchange for a 60-day, 13 percent note. 31 S old engines to Yu Company for $30,000 in exchange for a 90-day, 11 percent note. Required 1. For each of the notes, determine the (a) maturity date, (b) interest on the note, and (c) maturity value. 2. Assume that the fiscal year for Abraham Importing Company ends on June 30. How much interest income should be recorded on that date? User insight (cid:2) 3. What are the effects of the transactions in May on cash flows for the year ended June 30? 428 CHAPTER 9 Cash and Receivables ENHANCING Your Knowledge, Skills, and Critical Thinking LO1 Role of Credit Sales C 1. Mitsubishi Corp., a broadly diversified Japanese corporation, instituted a credit plan called Three Diamonds for customers who buy its major electronic products, such as large-screen televisions and videotape recorders, from specified retail dealers.18 Under the plan, approved customers who make purchases in July of one year do not have to make any payments until September of the next year. Nor do they have to pay interest during the intervening months. Mitsubishi pays the dealer the full amount less a small fee, sends the customer a Mitsubishi credit card, and collects from the customer at the specified time. What was Mitsubishi’s motivation for establishing such generous credit terms? What costs are involved? What are the accounting implications? LO1 LO3 Role of Estimates in Accounting for Receivables C 2. CompuCredit is a credit card issuer in Atlanta. It prides itself on making credit cards available to almost anybody in a matter of seconds over the Internet. The cost to the consumer is an interest rate of 28 percent, about double that of companies that provide cards only to customers with good credit. Despite its high interest rate, CompuCredit has been successful, reporting 1.9 million accounts and an income of approximately $100 million. To calculate its income, the company estimates that 10 percent of its $1.3 billion in accounts receivable will not be paid; the industry average is 7 percent. Some analysts have been criti- cal of CompuCredit for being too optimistic in its projections of losses.19 Why are estimates necessary in accounting for receivables? If CompuCredit were to use the same estimate of losses as other companies in its industry, what would its income have been for the year? How would one determine if Compu- Credit’s estimate of losses is reasonable? LO1 Receivables Financing C 3. Bernhardt Appliances, Inc., located in central Ohio, is a small manufacturer of washing machines and dryers. Bernhardt sells most of its appliances to large, established discount retail companies that market the appliances under their own names. Bernhardt sells the appliances on trade credit terms of n/60. If a customer wants a longer term, however, Bernhardt will accept a note with a term of up to nine months. At present, the company is having cash flow troubles and needs $10 million immediately. Its cash balance is $400,000, its accounts receivable balance

is $4.6 million, and its notes receivable balance is $7.4 million. How might Bernhardt Appliance’s management use its accounts receivable and notes receivable to raise the cash it needs? What are the company’s prospects for raising the needed cash? LO1 LO3 Ethics and Uncollectible Accounts C 4. Caldwell Interiors, a successful retail furniture company, is located in an afflu- ent suburb where a major insurance company has just announced a restructuring that will lay off 4,000 employees. Caldwell Interiors sells quality furniture, usually on credit. Accounts Receivable is one of its major assets. Although the company’s annual uncollectible accounts losses are not out of line, they represent a sizable amount. The company depends on bank loans for its financing. Sales and net income have declined in the past year, and some customers are falling behind in paying their accounts. Chapter Assignments 429 Abby Caldwell, the owner of the business, knows that the bank’s loan officer likes to see a steady performance. She has therefore instructed the company’s controller to underestimate the uncollectible accounts this year to show a small growth in earnings. Caldwell believes this action is justified because earnings in future years will average out the losses, and since the company has a history of success, she believes the adjustments are meaningless accounting measures anyway. Are Caldwell’s actions ethical? Would any parties be harmed by her actions? How important is it to try to be accurate in estimating losses from uncollectible accounts? LO1 LO2 Cash and Receivables LO3 C 5. Refer to CVS Corporation’s annual report in the Supplement to Chapter 5 to answer the following questions: 1. What amount of cash and cash equivalents did CVS Corporation have in 2008? Do you suppose most of that amount is cash in the bank or cash equivalents? 2. What customers represent the main source of CVS’s accounts receivable, and how much is CVS’s allowance for uncollectible accounts? LO1 Accounts Receivable Analysis C 6. Refer to the CVS annual report in the Supplement to Chapter 5 and to the following data (in millions) for Walgreens: net sales, $59,034.0 and $53,762.0 for 2008 and 2007, respectively; accounts receivable, net, $2,527.0 and $2,236.5 for 2008 and 2007, respectively. 1. Compute receivable turnover and days’ sales uncollected for 2008 and 2007 for CVS and Walgreens. Accounts Receivable in 2006 were $2,381.7 million for CVS and $2,062.7 million for Walgreens. 2. Do you discern any differences in the two companies’ credit policies? Explain your answer. C H A P T E R 10 Current Liabilities and Fair Value Accounting Making a A lthough some current liabilities, such as accounts payable, Statement are recorded when a company makes a purchase, others INCOME STATEMENT accrue during an accounting period and are not recorded until Revenues adjusting entries are made at the end of the period. In addition, the – Expenses value of some accruals must be estimated. If accrued liabilities are not recognized and valued properly, both liabilities and expenses = Net Income will be understated on the financial statements, making the com- pany’s performance look better than it actually is. STATEMENT OF OWNER’S EQUITY Beginning Balance LEARNING OBJECTIVES + Net Income – Withdrawals LO1 Identify the management issues related to current = Ending Balance liabilities. (pp. 432–436) LO2 Identify, compute, and record definitely determinable and BALANCE SHEET estimated current liabilities. (pp. 436–447) Assets Liabilities LO3 Distinguish contingent liabilities from commitments. (pp. 447–448) Owner’s Equity LO4 Identify the valuation approaches to fair value accounting, A = L + OE and define time value of money and interest and apply them to present values. (pp. 448–453) STATEMENT OF CASH FLOWS LO5 Apply present value to simple valuation situations. (pp. 453–455) Operating activities + Investing activities + Financing activities = Change in Cash + Beginning Balance = Ending Cash Balance Measurement of unearned revenues and accrued expenses impacts the amount of current

liabilities on the balance sheet and revenues and expenses on the income statement. 430 DECISION POINT (cid:2) A USER’S FOCUS (cid:2) How should Meggie Jones identify and account for all her MEGGIE’S FITNESS CENTER company’s current liabilities? (cid:2) How should she evaluate her In January 2009, Meggie Jones started a business called Meggie’s company’s liquidity? F itness Center. In addition to offering exercise classes, the center sells nutritional supplements. Meggie has limited experience in running a business, but she knows that it is extremely important for a com- pany, especially a new company, to manage its liabilities so that it has enough cash on hand to pay debts when they come due and that with- out a sufficient inflow of cash to do that, a company is likely to fail. Meggie is also well aware that incurring liabilities is a neces- sary part of doing business. When she started her business, Meggie signed over a promissory note to her bank for $16,000. To help oper- ate the business, she hired two exercise instructors to whom she pays monthly salaries, and she has incurred debt in maintaining an inven- tory of nutritional supplements. Because she has not yet filed any tax reports for her business, other liabilities include taxes owed to both the federal and state governments, as well as $3,600 in annual prop- erty taxes that the business owes the city government. As the company is approaching the end of its second fiscal year, Meggie is anxious to figure out what the company currently owes the government and other parties and to assess its liquidity. After reading this chapter, you will know how Meggie should identify, compute, and record her company’s current liabilities. You will also be familiar with the key measures used in evaluating liquidity. 431 432 CHAPTER 10 Current Liabilities and Fair Value Accounting Management Current liabilities require careful management of liquidity and cash flows, as well Issues Related to as close monitoring of accounts payable. In reporting on current liabilities, man- agers must understand how they should be recognized, valued, classified, and Current Liabilities disclosed. LO1 Identify the management issues related to current Managing Liquidity and Cash Flows liabilities. The primary reason a company incurs current liabilities is to meet its needs for cash during the operating cycle. As explained in Chapter 6, the operating cycle is the length of time it takes to purchase inventory, sell the inventory, and collect the resulting receivable. Most current liabilities arise in support of this cycle, as when accounts payable arise from purchases of inventory, accrued expenses arise from operating costs, and unearned revenues arise from custom- ers’ advance payments. Companies incur short-term debt to raise cash dur- ing periods of inventory buildup or while waiting for collection of receivables. They use the cash to pay the portion of long-term debt that is currently due and to pay liabilities arising from operations. Failure to manage the cash flows related to current liabilities can have seri- ous consequences for a business. For instance, if suppliers are not paid on time, they may withhold shipments that are vital to a company’s operations. Continued failure to pay current liabilities can lead to bankruptcy. To evaluate a company’s ability to pay its current liabilities, analysts often use two measures of liquidity— working capital and the current ratio, both of which we defined in an earlier chapter. Current liabilities are a key component of both these measures. They typically equal from 25 to 50 percent of total assets. As shown below (in millions), Nike’s short-term liquidity as measured by working capital and the current ratio was positive in 2008 and improved some- what in 2009. Current (cid:4) Current (cid:2) Working Current Assets Liabilities Capital Ratio* 2008 $8,839.3 (cid:4) $3,321.5 (cid:2) $5,517.8 2.66 2009 $9,734.0 (cid:4) $3,277.0 (cid:2) $6,457.0 2.97 The increase in Nike’s working capital and current ratio from 2008 to 2009 was caused primarily by a large increase in cash and short-term investments. Over-

all, Nike is in a strong current situation and exercises very good management of its cash flow. Evaluating Accounts Payable Another consideration in managing liquidity and cash flows is the time suppliers give a company to pay for purchases. Measures commonly used to assess a com- pany’s ability to pay within a certain time frame are payables turnover and days’ payable. Payables turnover is the number of times, on average, that a company pays its accounts payable in an accounting period. Days’ payable shows how long, on average, a company takes to pay its accounts payables. *Current assets divided by current liabilities. Management Issues Related to Current Liabilities 433 FOCUS ON BUSINESS PRACTICE Debt Problems Can Plague Even Well-Known Companies In a Wall Street horror story that illustrates the importance SEC, management acknowledged that it had tapped into its of managing current liabilities, Xerox Corporation, one of $7 billion line of bank credit for more than $3 billion to pay the most storied names in American business, found itself off short-term debt that was coming due. Unable to secure combating rumors that it was facing bankruptcy. Following more money from any other source to pay these debts, a statement by Xerox’s CEO that the company’s financial Xerox had no choice but to turn to the line of credit from model was “unsustainable,” management was forced to its bank. Had it run out, the company might well have gone defend the company’s liquidity by saying it had adequate bankrupt.1 Fortunately, Xerox was able to restructure its line funds to continue operations. But in a report filed with the of credit to stay in business. To measure payables turnover for Nike, we must first calculate purchases by adjusting cost of goods sold for the change in inventory. An increase in inven- tory means purchases were more than cost of goods sold; a decrease means pur- chases were less than cost of goods sold. Nike’s cost of goods sold in 2009 was $10,571.7 million, and its inventory decreased by $81.4 million. Its payables turnover is computed as follows (in millions): Cost of Goods Sold (cid:7) Change in Merchandise Inventory Payables Turnover (cid:2) Average Accounts Payable ($10,571.7 (cid:4) $81.4) (cid:2) ($2,883.9 (cid:3) $2,795.3) (cid:5) 2 $10,490.3 (cid:2) (cid:2) 3.7 Times $2,839.6 FIGURE 10-1 Times Payables Turnover for Selected Advertising 7.5 Industries Interstate 23.1 Trucking Auto and 9.6 Home Supply Grocery 21.0 Stores Machinery 10.6 Computers 6.2 0 5 10 15 20 25 30 Service Industries Merchandising Industries Manufacturing Industries Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006. 434 CHAPTER 10 Current Liabilities and Fair Value Accounting To find the days’ payable, the number of days in the accounting period is divided by the payables turnover: 365 Days Day’s Payable (cid:2) Payables Turnover 365 Days (cid:2) (cid:2) 98.6 Days 3.7 Times FIGURE 10-2 Days Days’ Payable for Selected Advertising 48.7 Industries Interstate 15.8 Trucking Auto and 38.0 Home Supply Grocery 17.4 Stores Machinery 34.4 Computers 58.9 0 5 10 15 20 25 30 35 40 45 50 55 60 Service Industries Merchandising Industries Manufacturing Industries Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006. The payables turnover of 3.7 times and days’ payable of 98.6 days indicate that the credit terms Nike receives from its suppliers are excellent and help offset the long inventory days’ on hand and days’ receivable outstanding calculated in prior chapters, thus, giving a full picture of Nike’s operating cycle and liquidity. Nike’s financing period is only 38.1 days (83.0 days’ inventory on hand (cid:3) 53.7 days’ sales uncollected (cid:4) 98.6 days’ payable). Nike’s suppliers are providing most of the financing of its operating cycle. In other industries, credit terms and product costs are not nearly as favor- able. As you can see in Figures 10-1 and 10-2, companies in other industries have higher payables turnover and lower days’ payable than Nike. Reporting Liabilities

In deciding whether to buy stock in a company or lend money to it, investors and creditors must evaluate not only the company’s current liabilities but its future obligations as well. In doing so, they have to rely on the integrity of the com- pany’s financial statements. Ethical reporting of liabilities requires that they be properly recognized, valued, classified, and disclosed. In one notable case involving unethical reporting of liabili- ties, the CEO and other employees of Nortel Networks Corporation, a Canadian manufacturer of telecommunications equipment, understated accrued liabilities (and corresponding expenses) in order to report a profit and obtain salary bonuses. After all accrued liabilities had been identified, it was evident that the company was in fact losing money. The board of directors of the corporation fired all who had been involved.2 Recognition Timing is important in the recognition of liabilities. Failure to record a liability in an accounting period very often goes along with failure to record an expense. The two errors lead to an understatement of expense and an overstatement of income. Management Issues Related to Current Liabilities 435 Generally accepted accounting principles require that a liability be recorded when an obligation occurs. This rule is harder to apply than it might appear. When a transaction obligates a company to make future payments, a liability arises and is recognized, as when goods are bought on credit. However, some current liabilities are not the result of direct transactions. One of the key reasons for making adjusting entries at the end of an accounting period is to recognize unrecorded liabilities that accrue during the period. Accrued liabilities include salaries payable and interest payable. Other liabilities that can only be estimated, such as taxes payable, must also be recognized through adjusting entries. Agreements for future transactions do not have to be recognized. For instance, Microsoft might agree to pay an executive $250,000 a year for a period of three years, or it might agree to buy an unspecified amount of advertising at a certain price over the next five years. Such contracts, though they are defi- nite commitments, are not considered liabilities because they are for future—not past—transactions. Because there is no current obligation, no liability is recog- nized, but they would be mentioned in the notes to the financial statements and SEC filings if material. Valuation On the balance sheet, a liability is generally valued at the amount of Study Note money needed to pay the debt or at the fair market value of the goods or services to be delivered. The amount of most liabilities is definitely known. For example, Disclosure of the fair value and the bases for estimating Amazon.com sells a large number of gift certificates that are redeemable in the the fair value of short-term future. The amount of the liability (unearned revenue) is known, but the exact notes payable, loans payable, timing is not known. and other short-term debt are Some companies, however, must estimate future liabilities. For example, required unless it is not practical an automobile dealer that sells a car with a one-year warranty must provide to estimate the value. Guidance parts and service during the year. The obligation is definite because the sale for determining fair value is has occurred, but the amount of the obligation can only be estimated. Such covered later in this chapter. estimates are usually based on past experience and anticipated changes in the business e nvironment. Classification As you may recall from our discussion of classified balance sheets in an earlier chapter, current liabilities are debts and obligations that a company expects to satisfy within one year or within its normal operating cycle, whichever is longer. These liabilities are normally paid out of current assets or with cash generated by operations. Long-term liabilities are liabilities due beyond one year or beyond the normal operating cycle. For example, Meggie’s

Fitness Center may incur long-term liabilities to finance its expansion to a new larger location, among other objectives. The distinction between current and long-term liabilities is important because it affects the evaluation of a company’s liquidity. Disclosure A company may have to include additional explanation of some liability accounts in the notes to its financial statements. For example, if a com- pany’s Notes Payable account is large, it should disclose the balances, maturity dates, interest rates, and other features of the debts in an explanatory note. Any special credit arrangements should also be disclosed. For example, in a note to its financial statements, Hershey Foods Corporation, the famous candy company, discloses the rationale for its credit arrangements: Borrowing Arrangements We maintain debt levels we consider prudent based on our cash flow, interest coverage ratio and percentage of debt to capital. We use debt financing to lower our overall cost of capital, which increases our return on stockholders’ equity.3 436 CHAPTER 10 Current Liabilities and Fair Value Accounting Unused lines of credit allow a company to borrow on short notice up to the credit limit, with little or no negotiation. Thus, the type of disclosure in Hershey’s note is helpful in assessing whether a company has additional borrowing power. STOP & APPLY Jackie’s Cookie Company has current assets of $30,000 and current liabilities of $20,000, of which accounts payable are $15,000. Jackie’s cost of goods sold is $125,000, its merchandise inventory increased by $5,000, and accounts payable were $11,000 the prior year. Calculate Jackie’s working capital, payables turnover, and days’ payable. SOLUTION Working Capital (cid:2) Current Assets (cid:4) Current Liabilities (cid:2) $30,000 (cid:4) $20,000 (cid:2) $10,000 Cost of Goods Sold (cid:7) Change in Inventory Payables Turnover (cid:2) Average Accounts Payable (cid:2) $125,000 (cid:3) $5,000 (cid:2) $130,000 ($15,000 (cid:3) $11,000) (cid:5) 2 $13,000 (cid:2) 10 Times Days’ Payable (cid:2) 365 Days (cid:5) Payables Turnover 365 Days (cid:2) (cid:2) 36.5 Days 10 Times Common Types of As noted earlier, a company incurs current liabilities to meet its needs for cash Current Liabilities during the operating cycle. These liabilities fall into two major groups: definitely determinable liabilities and estimated liabilities. LO2 Identify, compute, and Definitely Determinable Liabilities record definitely determinable and estimated current liabilities. Current liabilities that are set by contract or statute and that can be measured exactly are called definitely determinable liabilities. The problems in account- ing for these liabilities are to determine their existence and amount and to see that they are recorded properly. The most common definitely determinable liabilities are described below. Accounts Payable Accounts payable (sometimes called trade accounts pay- able) are short-term obligations to suppliers for goods and services. The amount in the Accounts Payable account is generally supported by an accounts payable subsidiary ledger, which contains an individual account for each person or com- pany to which money is owed. Common Types of Current Liabilities 437 Bank Loans and Commercial Paper Management often establishes a line Study Note of credit with a bank. This arrangement allows the company to borrow funds when they are needed to finance current operations. In a note to its financial On the balance sheet, the order statements, Goodyear Tire & Rubber Company describes its lines of credit as fol- of presentation for current lows: “In aggregate, we had credit arrangements of $8,208 million available at liabilities is not as strict as for current assets. Generally, December 31, 2006, of which $533 million were unused.”4 accounts payable or notes Although a company signs a promissory note for the full amount of a line of payable appear first, and the credit, it has great flexibility in using the available funds. It can increase its bor- rest of current liabilities follow. rowing up to the limit when it needs cash and reduce the amount borrowed when

it generates enough cash of its own. Both the amount borrowed and the interest rate charged by the bank may change daily. The bank may require the company to meet certain financial goals (such as maintaining specific profit margins, cur- rent ratios, or debt to equity ratios) to retain its line of credit. Companies with excellent credit ratings can borrow short-term funds by issu- ing commercial paper, which are unsecured loans (i.e., loans not backed up by any specific assets) that are sold to the public, usually through professionally man- aged investment firms. Highly rated companies rely heavily on commercial paper to raise short-term funds, but they can quickly lose access to this means of bor- rowing if their credit rating drops. Because of disappointing operating results in Study Note recent years, well-known companies like DaimlerChrysler, Lucent Technologies, Only the used portion of a and Motorola have lost some or all of their ability to issue commercial paper. line of credit is recognized The portion of a line of credit currently borrowed and the amount of com- as a liability in the financial mercial paper issued are usually combined with notes payable in the current lia- statements. bilities section of the balance sheet. Details are disclosed in a note to the financial statements. Notes Payable Short-term notes payable are obligations represented by prom- issory notes. A company may sign promissory notes to obtain bank loans, pay suppliers for goods and services, or secure credit from other sources. Interest is usually stated separately on the face of the note, as shown in Figure 10-3. The entries to record the note in Figure 10-3 follow. Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH NOTES PAYABLE Dr. Cr. Dr. Cr. Aug. 31 10,000 Aug. 31 10,000 ISSUANCE Entry in Journal Form: A (cid:3) L (cid:4) OE Dr. Cr. (cid:3)10,000 (cid:3)10,000 Aug. 31 Cash 10,000 Notes Payable 10,000 Issued 60-day, 12% promissory note FIGURE 10-3 Promissory Note Chicago, Illinois August 31, 2011 Sixty days after date I promise to pay First Federal Bank $10,000 the sum of with interest at the rate of 12% per annum. Caron Corporation 438 CHAPTER 10 Current Liabilities and Fair Value Accounting Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH NOTES PAYABLE INTEREST EXPENSE Dr. Cr. Dr. Cr. Dr. Cr. Oct. 30 10,197.26 Oct. 30 10,000.00 Oct. 30 197.26 Entry in Journal Form: Dr. Cr. Oct. 30 Notes Payable 10,000.00 Interest Expense 197.26 Cash 10,197.26 Payment of promissory note with interest $10,000 (cid:6) _1_2__ (cid:6) _6_0__ (cid:2) $197.26 100 365 PAYMENT A (cid:3) L (cid:4) OE (cid:4)10,197.26 (cid:4)10,000.00 (cid:4)197.26 Accrued Liabilities As we noted earlier, a key reason for making adjusting entries at the end of an accounting period is to recognize liabilities that are not already in the accounting records. This practice applies to any type of liability. As you will see, accrued liabilities (also called accrued expenses) can include estimated liabilities. Here, we focus on interest payable, a definitely determinable liability. Inter- est accrues daily on interest-bearing notes. In accordance with the matching rule, an adjusting entry is made at the end of each accounting period to record the interest obligation up to that point. For example, if the accounting period of the maker of the note in Figure 10-3 ends on September 30, or 30 days after the issu- ance of the 60-day note, the adjusting entry would be as follows: Assets (cid:2) Liabilities (cid:3) Owner’s Equity INTEREST PAYABLE INTEREST EXPENSE Dr. Cr. Dr. Cr. Sept. 30 98.63 Sept. 30 98.63 A (cid:3) L (cid:4) OE Entry in Journal Form: (cid:3)98.63 (cid:4)98.63 Dr. Cr. Sept. 30 Interest Expense 98.63 Interest Payable 98.63 To record 30 days’ interest expense on promissory note $10,000 (cid:6) _1_2__ (cid:6) _3_0__ (cid:2) $98.63 100 365 Dividends Payable As you know, cash dividends are a distribution of earnings to a corporation’s stockholders, and a corporation’s board of directors has the sole authority to declare them. The corporation has no liability for dividends until

the date of declaration. The time between that date and the date of payment of dividends is usually short. During this brief interval, the dividends declared are considered current liabilities of the corporation. Sales and Excise Taxes Payable Most states and many cities levy a sales tax on retail transactions, and the federal government imposes an excise tax on Common Types of Current Liabilities 439 some products, such as gasoline. A merchant that sells goods subject to these taxes must collect the taxes and forward them periodically to the appropriate government agency. Until the merchant remits the amount it has collected to the government, that amount represents a current liability. For example, suppose a merchant makes a $200 sale that is subject to a 5 percent sales tax and a 10 percent excise tax. If the sale takes place on June 1, the entry to record it is as follows: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH SALES TAX PAYABLE SALES Dr. Cr. Dr. Cr. Dr. Cr. June 1 230 June 1 10 June 1 200 EXCISE TAX PAYABLE Dr. Cr. June 1 20 A (cid:3) L (cid:4) OE Entry in Journal Form: (cid:3)230 (cid:3)10 (cid:3)200 Dr. Cr. (cid:3)20 June 1 Cash 230 Sales 200 Sales Tax Payable 10 Excise Tax Payable 20 Sales of merchandise and collection of sales and excise tax The sale is properly recorded at $200, and the taxes collected are recorded as liabilities to be remitted to the appropriate government agencies. Companies that have a physical presence in many cities and states require a complex accounting system for sales taxes because the rates vary from state to state and city to city. For Internet companies, the sales tax situation is simpler. For example, Amazon.com is an Internet company without a physical presence in most states and thus does not always have to collect sales tax from its customers, so its sales tax situation is simpler. This situation may change in the future, but so far Congress has exempted most Internet sales from sales tax. FOCUS ON BUSINESS PRACTICE Small Businesses Offer Benefits, Too Paid Vacation 77% Health/Medical A survey of small businesses in the Midwest focused on the 77% Benefits employee benefits that these companies offer. The graph Bonus 62% at the right presents the results. As you can see, 77 percent Flexible Hours 54% of respondents provided both paid vacation and health/ medical benefits, and 23 percent even offered their employ- Paid Sick Leave 41% ees tuition reimbursement.5 Profit-Sharing 35% Retirement Plan 34% Employee Leave 30% Tuition 23% Reimbursement 0 20 40 60 80 100 440 CHAPTER 10 Current Liabilities and Fair Value Accounting Current Portion of Long-Term Debt If a portion of long-term debt is due within the next year and is to be paid from current assets, that portion is classified as a current liability. It is common for companies to have portions of long-term debt, such as notes or mortgages, due in the next year. No journal entry is neces- sary when this is the case. The total debt is simply reclassified or divided into two categories—short-term and long-term—when the company prepares its balance sheet and other financial statements. Payroll Liabilities For most organizations, the cost of labor and payroll taxes is a major expense. In the banking and airlines industries, payroll costs represent more than half of all operating costs. Payroll accounting is important because complex laws and significant liabilities are involved. The employer is liable to employees for wages and salaries and to various agencies for amounts withheld from wages and salaries and for related taxes. Wages are compensation of employees at an hourly rate; salaries are compensation of employees at a monthly or yearly rate. Because payroll accounting applies only to an organization’s employees, it is important to distinguish between employees and independent contractors. Employees are paid a wage or salary by the organization and are under its direct supervision and control. Independent contractors are not employees of the orga- nization and so are not accounted for under the payroll system. They offer ser-

vices to the organization for a fee, but they are not under its direct control or supervision. Certified public accountants, advertising agencies, and lawyers, for example, often act as independent contractors. Study Note Figure 10-4 shows how payroll liabilities relate to employee earnings and In many organizations, a large employer taxes and other costs. When accounting for payroll liabilities, it is portion of the cost of labor is important to keep the following in mind: not reflected in employees’ (cid:2) The amount payable to employees is less than the amount of their earn- regular paychecks. Vacation ings. This occurs because employers are required by law or are requested by pay, sick pay, personal days, employees to withhold certain amounts from wages and send them directly health insurance, life insurance, to government agencies or other organizations. and pensions are some of the additional costs that may be (cid:2) An employer’s total liabilities exceed employees’ earnings because the negotiated between employers employer must pay additional taxes and make other contributions (e.g., for and employees. pensions and medical care) that increase the cost and liabilities. The most common withholdings, taxes, and other payroll costs are described below. Federal Income Taxes Employers are required to withhold federal income taxes from employees’ paychecks and pay them to the United States Treasury. These taxes are collected each time an employee is paid. State and Local Income Taxes Most states and some local governments levy income taxes. In most cases, the procedures for withholding are similar to those for federal income taxes. Social Security (FICA) Tax The Social Security program (the Federal Insurance Contribution Act) provides retirement and disability benefits and survivor’s ben- efits. About 90 percent of the people working in the United States fall under the Study Note provisions of this program. The 2009 Social Security tax rate of 6.2 percent was paid by both employee and employer on the first $106,800 earned by an employee The employee pays all federal, during the calendar year. Both the rate and the base to which it applies are subject state, and local taxes on income. to change in future years. The employer and employee share FICA and Medicare taxes. Medicare Tax A major extension of the Social Security program is Medicare, The employer bears FUTA and which provides hospitalization and medical insurance for persons over age 65. In state unemployment taxes. 2009, the Medicare tax rate was 1.45 percent of gross income, with no limit, paid by both employee and employer. Common Types of Current Liabilities 441 FIGURE 10-4 TOTAL PAYROLL EMPLOYER Illustration of Payroll Costs COSTS* LIABILITIES Payable to Take-Home Pay Employee Federal Income Taxes State and Local Income Taxes Employee’s FICA Tax Gross Wages Employee’s Payroll Deductions Medicare Tax Medical Insurance Payable to Federal Pension Government State and Local Governments Insurance Employer’s Share Companies of FICA Tax Pension Funds Others Employer’s Share of Medicare Tax Employer’s Share of Medical Insurance Employer Taxes and Other Costs Employer’s Share of Pension Federal Unemployment Tax State Unemployment Tax *Boxes are not proportional to amounts. Medical Insurance Many organizations provide medical benefits to employees. Often, the employee contributes a portion of the cost through withholdings from income and the employer pays the rest—usually a greater amount—to the insur- ance company. Pension Contributions Many organizations also provide pension benefits to employ- ees. A portion of the pension contribution is withheld from the employee’s income, and the organization pays the rest of the amount into the pension fund. 442 CHAPTER 10 Current Liabilities and Fair Value Accounting Federal Unemployment Insurance (FUTA) Tax This tax pays for programs for unemployed workers. It is paid only by employers and recently was 6.2 percent of the first $7,000 earned by each employee (this amount may vary from state to state). The employer is allowed a credit for unemployment taxes it pays to

the state. The maximum credit is 5.4 percent of the first $7,000 earned by each employee. Most states set their rate at this maximum. Thus, the FUTA tax most often paid is 0.8 percent (6.2 percent (cid:4) 5.4 percent) of the taxable wages. State Unemployment Insurance Tax State unemployment programs provide com- pensation to eligible unemployed workers. The compensation is paid out of the fund provided by the 5.4 percent of the first $7,000 (or whatever amount the state sets) earned by each employee. In some states, employers with favorable employ- ment records may be entitled to pay less than 5.4 percent. To illustrate the recording of a payroll, suppose that on February 15, a company’s wages for employees are $65,000 and withholdings for employees are $10,800 for federal income taxes, $2,400 for state income taxes, $4,030 for Social Security tax, $942 for Medicare tax, $1,800 for medical insurance, and $2,600 for pension contributions. The entry to record this payroll is as follows: A (cid:3) L (cid:4) OE Feb. 15 Wages Expense 65,000 (cid:3)10,800 (cid:4)65,000 Employees’ Federal Income Taxes Payable 10,800 (cid:3)2,400 Employees’ State Income Taxes Payable 2,400 (cid:3)4,030 Social Security Tax Payable 4,030 (cid:3)942 Medicare Tax Payable 942 (cid:3)1,800 Medical Insurance Premiums Payable 1,800 (cid:3)2,600 (cid:3)42,428 Pension Contributions Payable 2,600 Wages Payable 42,428 To record the payroll Note that although the employees earned $65,000, their take-home pay was only $42,428. Using the same data but assuming that the employer pays 80 percent of the medical insurance premiums and half of the pension contributions, the employer’s taxes and benefit costs would be recorded as follows: A (cid:3) L (cid:4) OE Feb. 15 Payroll Taxes and Benefits Expense 18,802 (cid:3)4,030 (cid:4)18,802 Social Security Tax Payable 4,030 (cid:3)942 Medicare Tax Payable 942 (cid:3)7,200 Medical Insurance Premiums Payable 7,200 (cid:3)2,600 Pension Contributions Payable 2,600 (cid:3)520 Federal Unemployment Tax Payable 520 (cid:3)3,510 State Unemployment Tax Payable 3,510 To record payroll taxes and other costs Note that the payroll taxes and benefits expense increase the total cost of the payroll to $83,802 ($18,802 (cid:3) $65,000), which exceeds the amount earned by employees by almost 29 percent. This is a typical situation. Unearned Revenues Unearned revenues are advance payments for goods or ser- vices that a company must provide in a future accounting period. It then recognizes the revenue over the period in which it provides the products or services. Assume Common Types of Current Liabilities 443 that Meggie’s Fitness Center receives the cash from a customer in advance for a one- year membership in the fitness center. The following entry would be made: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH UNEARNED REVENUE Dr. Cr. Dr. Cr. June 1 360 June 1 360 A (cid:3) L (cid:4) OE Entry in Journal Form: (cid:3)360 (cid:3)360 Dr. Cr. June 1 Cash 360 Unearned Revenue 360 Membership received in advance Meggie has a liability of $360 that will slowly be reduced over the year as it provides the service. After the first month, the company records the recognition of revenue as follows: Assets (cid:2) Liabilities (cid:3) Owner’s Equity UNEARNED REVENUE REVENUE Dr. Cr. Dr. Cr. June 30 30 June 30 30 A (cid:3) L (cid:4) OE Entry in Journal Form: (cid:4)30 (cid:3)30 Dr. Cr. Unearned Revenue 30 Revenue 30 Recognition of revenue for services provided Many businesses, including repair companies, construction companies, and special-order firms, ask for a deposit before they will begin work. Until they deliver the goods or services, these deposits are current liabilities. Estimated Liabilities Estimated liabilities are definite debts or obligations whose exact dollar amount cannot be known until a later date. Because there is no doubt that a legal obligation exists, the primary accounting problem is to estimate and record the amount of the liability. Examples of estimated liabilities follow. FOCUS ON BUSINESS PRACTICE Those Little Coupons Can Add Up

Many companies promote their products by issuing cou- issued annually. Of course, the liability depends on how pons that offer “cents off” or other enticements. Because many coupons will actually be redeemed. PROMO estimates four out of five shoppers use coupons, companies are that number at approximately 3.6 billion, or about 1.2 per- forced by competition to distribute them. The total value cent. Thus, a big advertiser that puts a cents-off coupon in of unredeemed coupons, each of which represents a poten- Sunday papers to reach 60 million people can be faced with tial liability for the issuing company, is staggering. PROMO liability for 720,000 coupons. The total value of coupons Magazine estimates that almost 300 billion coupons are redeemed each year is estimated at more than $3.6 billion.6 444 CHAPTER 10 Current Liabilities and Fair Value Accounting FOCUS ON BUSINESS PRACTICE What Is the Cost of Frequent Flyer Miles? In the early 1980s, American Airlines developed a fre- of passengers travel on “free” tickets. Estimated liabilities quent flyer program that awards free trips and other for these tickets have become an important consideration bonuses to customers based on the number of miles they in evaluating an airline’s financial position. Complicating fly on the airline. Since then, many other airlines have insti- the estimate is that almost half the miles have been earned tuted similar programs, and it is estimated that 40 million through purchases from hotels, car rental and telephone people now participate in them. Today, U.S. airlines have companies, Internet service providers like AOL, and bank more than 4 trillion “free miles” outstanding, and 8 percent credit cards.7 Income Taxes Payable The federal government, most state governments, Study Note and some cities and towns levy a tax on a corporation’s income. The amount of the liability depends on the results of a corporation’s operations, which are often Estimated liabilities are recorded not known until after the end of the corporation’s fiscal year. However, because and presented on the financial income taxes are an expense in the year in which income is earned, an adjusting statements in the same way entry is necessary to record the estimated tax liability. as definitely determinable liabilities. The only difference Sole proprietorships and partnerships do not pay income taxes. However, is that the computation of their owners must report their share of the firm’s income on their individual tax estimated liabilities involves returns. some uncertainty. Property Taxes Payable Property taxes are a main source of revenue for local governments. They are levied annually on real property, such as land and buildings, and on personal property, such as inventory and equipment. Because the fiscal years of local governments rarely correspond to a company’s fiscal year, it is necessary to estimate the amount of property taxes that applies to each month of the year. Promotional Costs You are no doubt familiar with the coupons and rebates that are part of many companies’ marketing programs and with the frequent flyer programs that airlines have been offering for more than 20 years. Companies usually record the costs of these programs as a reduction in sales (a contra-sales account) rather than as an expense with a corresponding current liability. As Her- shey Foods Corporation acknowledges in its annual report, promotional costs are hard to estimate: Accrued liabilities requiring the most difficult or subjective judgments include liabilities associated with marketing promotion programs. . . . We recognize the costs of marketing promotion programs as a reduction to net sales with a corresponding accrued liability based on estimates at the time of revenue recognition. . . . We determine the amount of the accrued liabil- ity by analysis of programs offered; historical trends; expectations regarding customer and consumer participation; sales and payment trends; and experi- ence . . . with previously offered programs.8 Hershey accrues over $600 million in promotional costs each year and reports

that its estimates are usually accurate within about 4 percent, or $24 million. Product Warranty Liability When a firm sells a product or service with a war- ranty, it has a liability for the length of the warranty. The warranty is a feature of the product and is included in the selling price; its cost should therefore be Common Types of Current Liabilities 445 debited to an expense account in the period of the sale. Based on past experience, Study Note it should be possible to estimate the amount the warranty will cost in the future. Some products will require little warranty service; others may require much. Thus, Recording a product warranty there will be an average cost per product. expense in the period of the For example, suppose a muffler company like Midas guarantees that it will sale is an application of the replace free of charge any muffler it sells that fails during the time the buyer owns matching rule. the car. The company charges a small service fee for replacing the muffler. In the past, 6 percent of the mufflers sold have been returned for replacement under the warranty. The average cost of a muffler is $50. If the company sold 700 mufflers during July, the accrued liability would be recorded as an adjustment at the end of July, as shown below: Assets (cid:2) Liabilities (cid:3) Owner’s Equity ESTIMATED PRODUCT WARRANTY LIABILITY PRODUCT WARRANTY EXPENSE Dr. Cr. Dr. Cr. July 31 2,100 July 31 2,100 A (cid:3) L (cid:4) OE Entry in Journal Form: (cid:3)2,100 (cid:4)2,100 Dr. Cr. July 31 Product Warranty Expense 2,100 Estimated Product Warranty Liability 2,100 To record estimated product warranty expense: Number of units sold 700 Rate of replacement under warranty × 0.06 Estimated units to be replaced 42 Estimated cost per unit × $50 Estimated liability for product warranty $2,100 When a muffler is returned for replacement under the warranty, the cost of the muffler is charged against the Estimated Product Warranty Liability account. For example, suppose that on December 5, a customer returns with a defective muffler, which cost $60, and pays a $30 service fee to have it replaced. The entry is as follows: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH ESTIMATED PRODUCT WARRANTY LIABILITY SERVICE REVENUE Dr. Cr. Dr. Cr. Dr. Cr. Dec. 5 30 Dec. 5 60 Dec. 5 30 MERCHANDISE INVENTORY Dr. Cr. Dec. 5 60 A (cid:3) L (cid:4) OE Entry in Journal Form: (cid:3)30 (cid:4)60 (cid:3)30 Dr. Cr. (cid:4)60 Dec. 5 Cash 30 Estimated Product Warranty Liability 60 Service Revenue 30 Merchandise Inventory 60 Replacement of muffler under warranty 446 CHAPTER 10 Current Liabilities and Fair Value Accounting Vacation Pay Liability In most companies, employees accrue paid vacation as they work during the year. For example, an employee may earn 2 weeks of paid vacation for each 50 weeks of work. Thus, the person is paid 52 weeks’ salary for 50 weeks’ work. The cost of the 2 weeks’ vacation should be allo- cated as an expense over the whole year so that month-to-month costs will not be distorted. The vacation pay represents 4 percent (two weeks’ vacation divided by 50 weeks) of a worker’s pay. Every week worked earns the employee a small fraction of vacation pay, which is 4 percent of total annual salary. Suppose that a company has a vacation policy of 2 weeks of paid vacation for each 50 weeks of work. It also has a payroll of $42,000 and paid $2,000 of that amount to employees on vacation for the week ended April 20. Because of turnover and rules regarding term of employment, the company assumes that only 75 percent of employees will ultimately collect vacation pay. The computa- tion of vacation pay expense based on the payroll of employees not on vacation ($42,000 (cid:4) $2,000) is as follows: $40,000 (cid:6) 4 percent (cid:6) 75 percent (cid:2) $1,200. The company would make the following entry to record vacation pay expense for the week ended April 20: Assets (cid:2) Liabilities (cid:3) Owner’s Equity ESTIMATED LIABILITY FOR VACATION PAY VACATION PAY EXPENSE Dr. Cr. Dr. Cr. Apr. 20 1,200 Apr. 20 1,200 A (cid:3) L (cid:4) OE Entry in Journal Form:

(cid:3)1,200 (cid:4)1,200 Dr. Cr. Apr. 20 Vacation Pay Expense 1,200 Estimated Liability for Vacation Pay 1,200 Estimated vacation pay expense At the time employees receive their vacation pay, an entry is made debiting Esti- mated Liability for Vacation Pay and crediting Cash or Wages Payable. This entry records the $2,000 paid to employees on vacation during August: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH ESTIMATED LIABILITY FOR VACATION PAY Dr. Cr. Dr. Cr. Aug. 31 2,000 Aug. 31 2,000 A* (cid:3) L (cid:4) OE Entry in Journal Form: (cid:4)2,000 (cid:4)2,000 Dr. Cr. Aug. 31 Estimated Liability for Vacation Pay 2,000 *Assumes cash paid. Cash (or Wages Payable) 2,000 Wages of employees on vacation The treatment of vacation pay presented here can also be applied to other payroll costs, such as bonus plans and contributions to pension plans. Contingent Liabilities and Commitments 447 STOP & APPLY Identify each of the following as either (1) a definitely determinable liability or (2) an estimated liability: ______ a. Bank loan ______ f. Vacation pay liability ______ b. Dividends payable ______ g. Notes payable ______ c. Product warranty liabilities ______ h. Property taxes payable ______ d. Interest payable ______ i. Commercial paper ______ e. Income taxes payable ______ j. Gift certificate liability SOLUTION a. 1; b. 1; c. 2; d. 1; e. 2; f. 2; g. 1; h. 2; i. 1; j. 1 Contingent The FASB requires companies to disclose in a note to their financial statements any contingent liabilities and commitments they may have. A contingent liability Liabilities and is not an existing obligation. Rather, it is a potential liability because it depends Commitments on a future event arising out of a past transaction. Contingent liabilities often involve lawsuits, income tax disputes, discounted notes receivable, guarantees of LO3 Distinguish contingent debt, and failure to follow government regulations. For instance, a construction liabilities from commitments. company that built a bridge may have been sued by the state for using poor mate- rials. The past transaction is the building of the bridge under contract. The future event is the outcome of the lawsuit, which is not yet known. The FASB has established two conditions for determining when a contin- gency should be entered in the accounting records: 1. The liability must be probable. Study Note 2. The liability can be reasonably estimated.9 Contingencies are recorded EEstimated liabilities like the income tax, warranty, and vacation pay liabilities when they are probable and can tthat we have described meet those conditions. They are therefore accrued in the be reasonably estimated. aaccounting records. In a survey of 600 large companies, the most common types of contingencies reported were litigation, which can involve many different issues, and environ- mental concerns, such as toxic waste cleanup.10 In a note to its financial state- ments, Microsoft describes contingent liabilities in the area of lawsuits involving potential infringement of European competition law, antitrust and overcharge actions, patent and intellectual property claims, and others. Microsoft’s manage- ment states: While we intend to vigorously defend these matters, there exists the pos- sibility of adverse outcomes that we estimate could be up to $4.15 billion in aggregate beyond recorded amounts.11 A commitment is a legal obligation that does not meet the technical require- ments for recognition as a liability and so is not recorded. The most common examples are purchase agreements and leases. For example, Microsoft also reports in its notes to the financial statements construction commitments in the amount of $821 million and purchase commitments in the amount of $1,824 million.12 Knowledge of these amounts is very important for planning cash flows in the coming year. 448 CHAPTER 10 Current Liabilities and Fair Value Accounting STOP & APPLY Indicate whether each of the following is (a) a contingent liability or (b) a commitment: 1. A tax dispute with the IRS 3. An agreement to purchase goods in the future

2. A long-term lease agreement 4. A potential lawsuit over a defective product SOLUTION 1. a; 2. b; 3. b; 4. a Valuation Recall that fair value is the price for which an asset or liability could be sold. As pointed out previously, the concept of fair value applies to financial assets, such Approaches to as cash equivalents, accounts receivable, and investments, and to liabilities, such Fair Value as accounts payable and short-term loans. Fair value is also applicable to deter- Accounting mining whether tangible assets such as inventories and long-term assets have sus- tained a permanent decline in value below their cost. The FASB identifies three approaches to measurement of fair value:13 LO4 Identify the valua- tion approaches to fair value (cid:2) Market approach. When available, external market transactions involving accounting, and define time identical or comparable assets or liabilities are ideal. For example, the market value of money and interest and approach is good for valuing investments and liabilities for which there is a apply them to present values. ready market. However, a ready market is not always available. For example, there may not be a market for special-purpose equipment. In these cases, other approaches must be used. (cid:2) Income (or cash flow) approach. The income approach, as defined by the FASB, converts future cash flows to a single present value. This approach is based on management’s best determination of the future cash amounts generated by an asset or payments that will be made for a liability. It is based on internally gener- ated information, which should be reasonable for the circumstances. (cid:2) Cost approach. The cost approach is based on the amount that currently would be required to replace an asset. For example, inventory is usually val- ued at lower of cost or market, where market is the replacement cost. For a plant asset, the replacement cost of a new asset must be adjusted to take into account the asset’s age, condition, depreciation, and obsolescence. Complicating factors may arise in applying the market and cost approaches, but conceptually they are relatively straightforward. The income or cash flow approach requires knowledge of interest and the time value of money, and present value techniques, as presented in the following sections. Interest and the Time Value of Money “Time is money” is a common expression. It derives from the concept of the time value of money, which refers to the costs or benefits derived from holding or not holding money over time. Interest is the cost of using money for a specific period. The interest associated with the time value of money is an important con- sideration in any kind of business decision. For example, if you sell a bicycle for $100 and hold that amount for one year without putting it in a savings account, Valuation Approaches to Fair Value Accounting 449 you have forgone the interest that the money would have earned. However, if you accept a note payable instead of cash and add the interest to the price of the bicycle, you will not forgo the interest that the cash could have earned. Simple interest is the interest cost for one or more periods when the princi- Study Note ppal sum—the amount on which interest is computed—stays the same from period tto period. Compound interest is the interest cost for two or more periods when In business, compound interest aafter each period, the interest earned in that period is added to the amount on is the most useful concept wwhich interest is computed in future periods. In other words, the principal sum of interest because it helps iis increased at the end of each period by the interest earned in that period. The decision makers choose among alternative courses of action. ffollowing two examples illustrate these concepts: EExample of Simple Interest Willy Wang accepts an 8 percent, $15,000 note due iin 90 days. How much will he receive at that time? The interest is calculated as follows: Interest (cid:2) Principal (cid:6) Rate (cid:6) Time (cid:2) $15,000.00 (cid:6) 8/100 (cid:6) 90/365

(cid:2) $295.89 Therefore, the total that Wang will receive is $15,295.89, calculated as follows: Total (cid:2) Principal (cid:3) Interest (cid:2) $15,000.00 (cid:3) $295.89 (cid:2) $15,295.89 Example of Compound Interest Terry Soma deposits $10,000 in an account that pays 6 percent interest. She expects to leave the principal and accumulated interest in the account for three years. How much will the account total at the end of three years? Assume that the interest is paid at the end of the year and is added to the principal at that time, and that this total in turn earns interest. The amount at the end of three years is computed as follows: Principal Amount Annual Amount Accumulated Amount at Beginning of of Interest at End of Year Year Year (Col. 2 (cid:5) 6%) (Col. 2 (cid:4) Col. 3) 1 $10,000.00 $600.00 $10,600.00 2 10,600.00 636.00 11,236.00 3 11,236.00 674.16 11,910.16 At the end of three years, Soma will have $11,910.16 in her account. Note that the amount of interest increases each year by the interest rate times the interest of the previous year. For example, between year 1 and year 2, the interest increased by $36, which equals 6 percent times $600. The final amount of $11,910.16 is referred to as the future value, which is the amount an investment ($10,000 in this case) will be worth at a future date if invested at compound interest. Study Note Present value is a method of Calculating Present Value valuing future cash flows. Financial Suppose you had the choice of receiving $100 today or one year from today. No analysts commonly compute present value to determine the doubt, you would choose to receive it today. Why? If you have the money today value of potential investments. you can put it in a savings account to earn interest so you will have more than $100 a year from today. In other words, an amount to be received in the future 450 CHAPTER 10 Current Liabilities and Fair Value Accounting (future value) is not worth as much today as an amount received today (present value). Present value is the amount that must be invested today at a given rate of interest to produce a given future value. Thus, present value and future value are closely related. For example, suppose Kelly Fontaine needs $10,000 one year from now. How much does she have to invest today to achieve that goal if the interest rate is 5 percent? From earlier examples, we can establish the following equation: Present Value (cid:6) (1.0 (cid:3) Interest Rate) (cid:2) Future Value Present Value (cid:6) 1.05 (cid:2) $10,000.00 Present Value (cid:2) $10,000.00 (cid:5) 1.05 Present Value (cid:2) $9,523.81 To achieve a future value of $10,000, Fontaine must invest a present value of $9,523.81. Interest of 5 percent on $9,523.81 for one year equals $476.19, and these two amounts added together equal $10,000. Present Value of a Single Sum Due in the Future When more than one period is involved, the calculation of present value is more complicated. For example, suppose Ron More wants to be sure of having $8,000 at the end of three years. How much must he invest today in a 5 percent savings account to achieve this goal? We can compute the present value of $8,000 at compound interest of 5 percent for three years by adapting the above equation: Amount Present Value at at Year End of Year Divide by Beginning of Year 3 $8,000.00 (cid:5) 1.05 (cid:2) $7,619.05 2 7,619.05 (cid:5) 1.05 (cid:2) 7,256.24 1 7,256.24 (cid:5) 1.05 (cid:2) 6,910.70 Ron More must invest $6,910.70 today to achieve a value of $8,000 in three years. We can simplify the calculation by using the appropriate table. In Table 10-1, the point at which the 5 percent column and the row for period 3 intersect shows a factor of 0.864. This factor, when multiplied by $1, gives the present value of $1 to be received three years from now at 5 percent interest. Thus, we solve the problem as follows: Future Value: $8,000 Year 1 Year 2 Year 3 Present Value: $6,912 Future Value (cid:6) Factor (cid:2) Present Value $8,000 (cid:6) 0.864 (cid:2) $6,912 Except for a rounding difference of $1.30, this result is the same as our earlier one.

Present Value of an Ordinary Annuity It is often necessary to compute the present value of a series of receipts or payments equally spaced over time—in other words, the present value of an ordinary annuity. For example, suppose Vickie Long has sold a piece of property and is to receive $18,000 in three equal Valuation Approaches to Fair Value Accounting 451 annual payments of $6,000 beginning one year from today. What is the present value of this sale if the current interest rate is 5 percent? Using Table 10-1, we can compute the present value by calculating a separate value for each of the three payments and summing the results, as follows: Future Receipts (Annuity) Present Value Factor at 5 Percent Year 1 Year 2 Year 3 (from Table 10-1) Present Value $6,000 (cid:6) 0.952 (cid:2) $ 5,712 $6,000 (cid:6) 0.907 (cid:2) 5,442 $6,000 (cid:6) 0.864 (cid:2) 5,184 Total Present Value $16,338 The present value of the sale is $16,338. Thus, there is an implied interest cost (given the 5 percent rate) of $1,662 associated with the payment plan that allows the purchaser to pay in three installments. We can make this calculation more easily by using Table 10-2. The point at which the 5 percent column intersects the row for period 3 shows a factor of 2.723. When multiplied by $1, this factor gives the present value of a series of three $1 payments (spaced one year apart) at compound interest of 5 percent. Thus, we solve the problem as follows: Payment: $6,000 Payment: $6,000 Payment: $6,000 Year 1 Year 2 Year 3 Present Value: $16,338 Periodic Payment (cid:6) Factor (cid:2) Present Value $6,000 (cid:6) 2.723 (cid:2) $16,338 This result is the same as the one we computed earlier. TABLE 10-1 Present Value of $1 to Be Received at the End of a Given Number of Periods Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 452 CHAPTER 10 Current Liabilities and Fair Value Accounting TABLE 10-2 Present Value of an Ordinary $1 Annuity Received in Each Period for a Given Number of Periods Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 Time Periods As in all our examples, the compounding period is in most cases Study Note one year, and the interest rate is stated on an annual basis. However, the left-hand The interest rate used when column in Tables 10-1 and 10-2 refers not to years but to periods. This word- compounding interest for less ing accommodates compounding periods of less than one year. Savings accounts than one year is the annual that record interest quarterly and bonds that pay interest semiannually are cases rate divided by the number of in which the compounding period is less than one year. To use the tables in these periods in a year. cases, it is necessary to (1) divide the annual interest rate by the number of peri- ods in the year and (2) multiply the number of periods in one year by the number of years.

For example, suppose we want to compute the present value of a $6,000 payment that is to be received in two years, assuming an annual interest rate of 8 percent. The compounding period is semiannual. Before using Table 10-1 in this computation, we must compute the interest rate that applies to each com- pounding period and the total number of compounding periods. First, the inter- est rate to use is 4 percent (8% annual rate (cid:5) 2 periods per year). Second, the total number of compounding periods is 4 (2 periods per year (cid:6) 2 years). From Table 10-1, therefore, the present value of the payment is computed as follows: Principal (cid:6) Factor (cid:2) Present Value $6,000 (cid:6) 0.855 (cid:2) $5,130 The present value of the payment is $5,130. This procedure is used anytime the corresponding period is less than one year. For example, a monthly compounding requires dividing the annual interest rate by 12 and multiplying the number of years by 12 to use the tables. This method of determining the interest rate and the number of periods when the compounding period is less than one year can be used with Tables 10-1 and 10-2. Applications Using Present Value 453 STOP & APPLY Use Tables 10-1 and 10-2 to determine the present value of (1) a single payment of $10,000 at 5 percent for 10 years, (2) 10 annual payments of $1,000 at 5 percent, (3) a single payment of $10,000 at 7 percent for 5 years, and (4) 10 annual payments of $1,000 at 9 percent. SOLUTION 1. From Table 10-1: $10,000 (cid:6) 0.614 (cid:2) $6,140 2. From Table 10-2: $1,000 (cid:6) 7.722 (cid:2) $7,722 3. From Table 10-1: $10,000 (cid:6) 0.713 (cid:2) $7,130 4. From Table 10-2: $1,000 (cid:6) 6.418 (cid:2) $6,418 Applications The concept of present value is widely used in business decision making and finan- cial reporting. As mentioned above, the FASB has made it the foundation of its Using Present approach in determining the fair value of assets and liabilities when a ready mar- Value ket price is not available. For example, the value of a long-term note receivable or payable can be determined by calculating the present value of the future interest LO5 Apply the present value to payments. simple valuation situations. The Office of the Chief Accountant of the SEC has issued guidance on how to apply fair value accounting.14 For instance, it says that management’s internal assumptions about expected cash flows may be used to measure fair value and that market quotes may be used when they are from an orderly, active market as opposed to a distressed, inactive market. Thus, Microsoft may determine the expected present value of the future cash flows of an investment by using its inter- nal cash flow projections and a market rate of interest. By comparing the result to the current value of the investment, Microsoft can determine if an adjustment needs to be made to record a gain or loss. In the sections that follow, we illustrate two simple, useful applications of present value, which will be helpful in understanding the uses of present value in subsequent chapters. Valuing an Asset An asset is something that will provide future benefits to the company that owns it. Usually, the purchase price of an asset represents the present value of those future benefits. It is possible to evaluate a proposed purchase price by comparing it with the present value of the asset to the company. For example, Mike Yeboah is thinking of buying a new machine that will reduce his annual labor cost by $1,400 per year. The machine will last eight years. The interest rate that Yeboah assumes for making managerial decisions is 10 per- cent. What is the maximum amount (present value) that Yeboah should pay for the machine? The present value of the machine to Yeboah is equal to the present value of an ordinary annuity of $1,400 per year for eight years at compound 454 CHAPTER 10 Current Liabilities and Fair Value Accounting interest of 10 percent. Using the factor from Table 10-2, we compute the value as follows: Savings: $1,400 Savings: $1,400 Year 1 Years 2–7 Year 8

Present Value: $7,469 Periodic Savings (cid:6) Factor (cid:2) Present Value $1,400 (cid:6) 5.335 (cid:2) $7,469 Yeboah should not pay more than $7,469 for the machine because this amount equals the present value of the benefits he would receive from owning it. Deferred Payment To encourage buyers to make a purchase, sellers sometimes agree to defer pay- ment for a sale. This practice is common among companies that sell agricultural equipment; to accommodate farmers who often need new equipment in the spring but cannot pay for it until they sell their crops in the fall, these companies are willing to defer payment. Suppose Field Helpers Corporation sells a tractor to Sasha Ptak for $100,000 on February 1 and agrees to take payment ten months later, on December 1. Companies that sell agricultural equipment like these combine har- vesters often agree to defer payment for a sale. This practice is common because farmers often need new equipment in the spring but cannot pay for it until they sell their crops in the fall. Deferred payment is a use- ful application of the time value of money. Courtesy of istockphoto.com. Applications Using Present Value 455 When such an agreement is made, the future payment includes not only the sell- ing price but also an implied (imputed) interest cost. If the prevailing annual interest rate for such transactions is 12 percent compounded monthly, the actual price of the tractor would be the present value of the future payment, computed using the factor from Table 10-1 (10 periods, 1 percent [12 percent divided by 12 months]), as follows: Payment: $100,000 Month 1 Months 2–9 Month 10 Present Value: $90,500 Future Payment (cid:6) Factor (cid:2) Present Value $100,000 (cid:6) 0.905 (cid:2) $90,500 Ptak records the present value, $90,500, in his purchase records, and Field Helpers Corporation records it in its sales records. The balance consists of interest expense or interest income. Other Applications There are many other applications of present value in accounting, including com- puting imputed interest on non-interest-bearing notes, accounting for install- ment notes, valuing a bond, and recording lease obligations. Present value is also applied in accounting for pension obligations; valuing debt; depreciating prop- erty, plant, and equipment; making capital expenditure decisions; and generally in accounting for any item in which time is a factor. STOP & APPLY Jerry owns a restaurant and has the opportunity to buy a high-quality espresso coffee machine for $5,000. After carefully studying projected costs and revenues, Jerry estimates that the machine will produce a net cash flow of $1,600 annually and will last for five years. He determines that an interest rate of 10 percent is an adequate return on investment for his business. Calculate the present value of the machine to Jerry. Based on your calculation, do you think a decision to purchase the machine would be wise? SOLUTION Calculation of the present value: Annual cash flow $ 1,600.00 Factor from Table 10-2 (5 years at 10%) (cid:6) 3.791 Present value of net cash flows $ 6,065.60 Less purchase price (cid:4)5,000.00 Net present value $ 1,065.60 The present value of the net cash flows from the machine exceeds the purchase price. Thus, the investment will return more than 10 percent to Jerry’s business. A decision to purchase the machine would therefore be wise. 456 CHAPTER 10 Current Liabilities and Fair Value Accounting (cid:2) MEGGIE’S FITNESS CENTER: REVIEW PROBLEM In the Decision Point at the beginning of the chapter, we noted that Meggie Jones, owner of Meggie’s Fitness Center, was anxious to assess her company’s status at the end of its first year of operations. We posed the following questions: • How should Meggie Jones identify and account for all her company’s current liabilities? • How should she evaluate her company’s liquidity? Meggie compiled the following list (as of December 31, 2010): Unpaid invoices for nutritional supplements $12,000 Sales of nutritional supplements (excluding sales tax) 57,000 Cost of nutritional supplements sold 33,600

Exercise instructors’ salaries 22,800 Exercise revenues 81,400 Current Liabilities and Promissory note 16,000 Property taxes 3,600 Liquidity Analysis Current assets 40,000 LO1 LO2 Nutritional supplements inventory (12/31/10) 27,000 Nutritional supplements inventory (12/31/09) 21,000 In addition to the items on this list, Meggie’s Fitness Center sold gift certificates in the amount of $700 that have not been redeemed. It also deducted $1,374 from its two employees’ salaries for federal income taxes owed to the government. The current Social Security tax is 6.2 percent of maximum earnings of $102,000 for each employees and the current Medicare tax is 1.45 percent (no maximum earnings). The FUTA tax is 5.4 percent to the state and 0.8 percent to the federal government on the first $7,000 earned by each employee; both employees earned more than $7,000. Meggie has not filed a sales tax report to the state (6 percent of supplements sales). Required 1. Given these facts, determine the company’s current liabilities as of December 31, 2010. 2. User insight: Your analysis of the company’s current liabilities has been based on documents that the owner showed you. What liabilities may be missing from your analysis? 3. User insight: Evaluate the company’s liquidity by calculating working capital, payables turnover, and days’ payable. Comment on the results. (Assume average accounts payable were the same as year-end accounts payable.) Meggie’s Fitness Center: Review Problem 457 Answers to 1. The current liabilities of Meggie’s Fitness Center as of December 31, 2010, are as Review Problem follows: 2. The company may have current liabilities for which you have not seen any documentary evidence. For instance, invoices for accounts payable could be missing. In addition, the company may have accrued liabilities, such as vacation pay for its two employees, which would require establishing an estimated liability. If the promissory note to Lee’s bank is interest-bearing, it also would require an adjustment to accrue interest payable, and the company could have other loans outstanding for which you have not seen documentary evidence. Moreover, it may have to pay penalties and interest to the federal and state governments because of its failure to remit tax payments on a timely basis. City and state income tax withholding for the employees could be another overlooked liability. 3. Liquidity ratios computed and evaluated: Meggie’s Fitness Center has a negative working capital of $251.80, its payables turnover is only 3.3 times, and it takes an average of 110.6 days to pay its accounts payable. Its liquidity is therefore highly questionable. Many of its current assets are inventory, which it must sell to generate cash, and it must pay most of its current liabilities sooner than the 110.6 days would indicate. 458 CHAPTER 10 Current Liabilities and Fair Value Accounting STOP & REVIEW LO1 Identify the manage- Current liabilities are an important consideration in managing a company’s ment issues related to liquidity and cash flows. Key measures of liquidity are working capital, payables current liabilities. turnover, and days’ payable. Liabilities result from past transactions and should be recognized at the time a transaction obligates a company to make future pay- ments. They are valued at the amount of money necessary to satisfy the obligation or at the fair value of the goods or services to be delivered. Liabilities are classified as current or long-term. Supplemental disclosure is required when the nature or details of the obligations would help in understanding the liability. LO2 Identify, compute, and The two major categories of current liabilities are definitely determinable liabili- record defi nitely deter- ties and estimated liabilities. Definitely determinable liabilities can be measured minable and estimated exactly. They include accounts payable, bank loans and commercial paper, notes current liabilities. payable, accrued liabilities, dividends payable, sales and excise taxes payable, the current portion of long-term debt, payroll liabilities, and unearned revenues.

Estimated liabilities definitely exist, but their amounts are uncertain and must be estimated. They include liabilities for income taxes, property taxes, promo- tional costs, product warranties, and vacation pay. LO3 Distinguish contin- A contingent liability is a potential liability that arises from a past transaction gent liabilities from and is dependent on a future event. Contingent liabilities often involve lawsuits, commitments. income tax disputes, discounted notes receivable, guarantees of debt, and failure to follow government regulations. A commitment is a legal obligation, such as a purchase agreement, that is not recorded as a liability. LO4 Identify the valuation Three approaches to measurement of fair value are market, income (or cash flow), approaches to fair value and cost. The time value of money refers to the costs or benefits derived from accounting, and defi ne holding or not holding money over time. time value of money and Interest is the cost of using money for a specific period. In the computation interest and apply them of simple interest, the amount on which the interest is computed stays the same to present values. from period to period. In the computation of compound interest, the interest for a period is added to the principal amount before the interest for the next period is computed. Future value is the amount an investment will be worth at a future date if invested at compound interest. Present value is the amount that must be invested today at a given rate of interest to produce a given future value. An ordinary annuity is a series of equal payments made at the end of equal intervals of time, with compound interest on the payments. The present value of an ordinary annuity is the present value of a series of payments. Calculations of present values are simplified by using the appropriate tables, which appear in an appendix to this book. LO5 Apply present value to Present value is commonly used in determining fair value and may be used in simple valuation determining the value of an asset, in computing the present value of deferred pay- situations. ments, in establishing a fund for loan repayment, and in numerous other account- ing situations in which time is a factor. Stop & Review 459 REVIEW of Concepts and Terminology The following concepts and terms Estimated liabilities 443 (LO2) Simple interest 449 (LO4) were introduced in this chapter: Future value 449 (LO4) Time value of money 448 (LO4) Commercial paper 437 (LO2) Interest 448 (LO4) Unearned revenues 442 (LO2) Commitment 447 (LO3) Line of credit 437 (LO2) Wages 440 (LO2) Compound interest 449 (LO4) Long-term liabilities 435 (LO1) Contingent liability 447 (LO3) Key Ratios Ordinary annuity 450 (LO4) Current liabilities 435 (LO1) Days’ payable 432 (LO1) Present value 450 (LO4) Definitely determinable Payables turnover 432 (LO1) Salaries 440 (LO2) liabilities 436 (LO2) 460 CHAPTER 10 Current Liabilities and Fair Value Accounting CHAPTER ASSIGNMENTS BUILDING Your Basic Knowledge and Skills Short Exercises LO1 Issues in Accounting for Liabilities SE 1. Indicate whether each of the following actions relates to (a) managing liquidity and cash flow, (b) recognition of liabilities, (c) valuation of liabilities, (d) classification of liabilities, or (e) disclosure of liabilities: 1. Determining that a liability will be paid in less than one year 2. Estimating the amount of a liability 3. Providing information about when liabilities are due and their interest rates 4. Determining when a liability arises 5. Assessing working capital and payables turnover LO1 Measuring Short-Term Liquidity SE 2. Robinson Company has current assets of $65,000 and current liabilities of $40,000, of which accounts payable are $35,000. Robinson’s cost of goods sold is $230,000, its merchandise inventory increased by $10,000, and accounts pay- able were $25,000 the prior year. Calculate Robinson’s working capital, payables turnover, and days’ payable. LO2 LO3 Types of Liabilities SE 3. Indicate whether each of the following is (a) a definitely determinable

liability, (b) an estimated liability, (c) a commitment, or (d) a contingent liability: 1. Dividends payable 5. Vacation pay liability 2. Pending litigation 6. Guaranteed loans of another company 3. Income taxes payable 7. Purchase agreement 4. Current portion of long-term debt LO2 Interest Expense on Note Payable SE 4. On the last day of August, Avenue Company borrowed $240,000 on a bank note for 60 days at 12 percent interest. Assume that interest is stated separately. Prepare the following entries in journal form: (1) August 31, recording of note; and (2) October 30, payment of note plus interest. LO2 Payroll Expenses SE 5. The following payroll totals for the month of April are from the payroll register of Young Corporation: salaries, $223,000; federal income taxes with- held, $31,440; Social Security tax withheld, $13,826; Medicare tax withheld, $3,234; medical insurance deductions, $6,580; and salaries subject to unem- ployment taxes, $156,600. Determine the total and components of (1) the monthly payroll and (2) employer payroll expenses, assuming Social Security and Medicare taxes equal to the amounts for employees, a federal unemployment insurance tax of Chapter Assignments 461 0.8 percent, a state unemployment tax of 5.4 percent, and medical insurance premiums for which the employer pays 80 percent of the cost. LO2 Product Warranty Liability SE 6. Harper Corp. manufactures and sells travel clocks. Each clock costs $12.50 to produce and sells for $25. In addition, each clock carries a warranty that pro- vides for free replacement if it fails during the two years following the sale. In the past, 5 percent of the clocks sold have had to be replaced under the warranty. During October, Harper sold 52,000 clocks, and 2,800 clocks were replaced under the warranty. Prepare entries in journal form to record the estimated liabil- ity for product warranties during the month and the clocks replaced under war- ranty during the month. Note: Tables 1 and 2 in the appendix on present value tables may be used where appropriate to solve SE 7, SE 8, and SE 9. LO4 Simple and Compound Interest SE 7. Ursus Motors, Inc., receives a one-year note that carries a 12 percent annual interest rate on $6,000 for the sale of a used car. Compute the maturity value under each of the following assumptions: (1) Simple interest is charged. (2) The interest is compounded semiannually. LO4 Present Value Calculations SE 8. Find the present value of (1) a single payment of $24,000 at 6 percent for 12 years, (2) 12 annual payments of $2,000 at 6 percent, (3) a single payment of $5,000 at 9 percent for five years, and (4) five annual payments of $5,000 at 9 percent. LO4 LO5 Valuing an Asset for the Purpose of Making a Purchasing Decision SE 9. Hogan Whitner owns a machine shop and has the opportunity to purchase a new machine for $30,000. After carefully studying projected costs and revenues, Whitner estimates that the new machine will produce a net cash flow of $7,200 annually and will last for eight years. Whitner believes that an interest rate of 10 percent is adequate for his business. Calculate the present value of the machine to Whitner. Does the purchase appear to be a smart business decision? Exercises LO1 LO2 Discussion Questions LO3 E1. Develop a brief answer to each of the following questions: 1. Nimish Banks, a star college basketball player, received a contract from the Midwest Blazers to play professional basketball. The contract calls for a salary of $420,000 a year for four years, dependent on his making the team in each of those years. Should this contract be considered a liability and recorded on the books of the basketball team? Why or why not? 2. Is increasing payables turnover good or bad for a company? Why or why not? 3. Do adjusting entries involving estimated liabilities and accruals ever affect cash flows? 4. When would a commitment be recognized in the accounting records? 462 CHAPTER 10 Current Liabilities and Fair Value Accounting LO4 Discussion Questions E 2. Develop a brief answer to each of the following questions:

1. Is a friend who borrows money from you for three years and agrees to pay you interest after each year paying you simple or compound interest? 2. Ordinary annuities assume that the first payment is made at the end of each year. In a transaction, who is better off in this arrangement, the payer or the receiver? Why? 3. Why is present value one of the most useful concepts in making business decisions? LO1 Issues in Accounting for Liabilities E 3. Indicate whether each of the following actions relates to (a) managing liquidity and cash flows, (b) recognition of liabilities, (c) valuation of liabilities, (d) classification of liabilities, or (e) disclosure of liabilities: 1. Setting a liability at the fair market value of goods to be delivered 2. Relating the payment date of a liability to the length of the operating cycle 3. Recording a liability in accordance with the matching rule 4. Providing information about financial instruments on the balance sheet 5. Estimating the amount of “cents-off” coupons that will be redeemed 6. Categorizing a liability as long-term debt 7. Measuring working capital 8. Comparing days’ payable with last year LO1 Measuring Short-Term Liquidity E 4. In 2010, Hagler Company had current assets of $310,000 and current liabili- ties of $200,000, of which accounts payable were $130,000. Cost of goods sold was $850,000, merchandise inventory increased by $80,000, and accounts payable were $110,000 in the prior year. In 2011, Hagler had current assets of $420,000 and current liabilities of $320,000, of which accounts payable were $150,000. Cost of goods sold was $950,000, and merchandise inventory decreased by $30,000. Calculate Hagler’s working capital, payables turnover, and days’ payable for 2010 and 2011. Assess Hagler’s liquidity and cash flows in relation to the change in pay- ables turnover from 2010 to 2011. LO2 Interest Expense on Note Payable E 5. On the last day of October, Wicker Company borrows $120,000 on a bank note for 60 days at 11 percent interest. Interest is not included in the face amount. Prepare the following entries in journal form: (1) October 31, recording of note; (2) November 30, accrual of interest expense; and (3) December 30, payment of note plus interest. LO2 Sales and Excise Taxes E 6. Web Design Services billed its customers a total of $490,200 for the month of August, including 9 percent federal excise tax and 5 percent sales tax. 1. Determine the proper amount of service revenue to report for the month. 2. Prepare an entry in journal form to record the revenue and related liabilities for the month. LO2 Payroll Expenses E 7. At the end of October, the payroll register for Global Tool Corporation contained the following totals: wages, $742,000; federal income taxes withheld, Chapter Assignments 463 $189,768; state income taxes withheld, $31,272; Social Security tax with- held, $46,004; Medicare tax withheld, $10,759; medical insurance deductions, $25,740; and wages subject to unemployment taxes, $114,480. Determine the total and components of the (1) monthly payroll and (2) employer payroll expenses, assuming Social Security and Medicare taxes equal to the amount for employees, a federal unemployment insurance tax of 0.8 per- cent, a state unemployment tax of 5.4 percent, and medical insurance premiums for which the employer pays 80 percent of the cost. LO2 Product Warranty Liability E 8. Sanchez Company manufactures and sells electronic games. Each game costs $50 to produce, sells for $90, and carries a warranty that provides for free replacement if it fails during the two years following the sale. In the past, 7 percent of the games sold had to be replaced under the warranty. During July, Sanchez sold 6,500 games, and 700 games were replaced under the warranty. 1. Prepare an entry in journal form to record the estimated liability for product warranties during the month. 2. Prepare an entry in journal form to record the games replaced under warranty during the month. LO2 Vacation Pay Liability E 9. Angel Corporation gives three weeks’ paid vacation to each employee who

has worked at the company for one year. Based on studies of employee turnover and previous experience, management estimates that 65 percent of the employees will qualify for vacation pay this year. 1. Assume that Angel’s July payroll is $150,000, of which $10,000 is paid to employees on vacation. Figure the estimated employee vacation benefit for the month. 2. Prepare an entry in journal form to record the employee benefit for July. 3. Prepare an entry in journal form to record the pay to employees on vacation. Note: Tables 1 and 2 in the appendix on present value tables may be used where appropriate to solve E 10 through E 16. LO4 LO5 Determining an Advance Payment E 10. Tracy Collins is contemplating paying five years’ rent in advance. Her annual rent is $25,200. Calculate the single sum that would have to be paid now for the advance rent if we assume compound interest of 8 percent. LO4 Present Value Calculations E 11. Find the present value of (1) a single payment of $24,000 at 6 percent for 12 years, (2) 12 annual payments of $2,000 at 6 percent, (3) a single payment of $5,000 at 9 percent for five years, and (4) 5 annual payments of $5,000 at 9 percent. LO4 LO5 Present Value of a Lump-Sum Contract E 12. A contract calls for a lump-sum payment of $15,000. Find the present value of the contract, assuming that (1) the payment is due in five years and the c urrent interest rate is 9 percent; (2) the payment is due in ten years and the current interest rate is 9 percent; (3) the payment is due in five years and the c urrent interest rate is 5 percent; and (4) the payment is due in ten years and the current interest rate is 5 percent. 464 CHAPTER 10 Current Liabilities and Fair Value Accounting LO4 LO5 Present Value of an Annuity Contract E 13. A contract calls for annual payments of $1,200. Find the present value of the contract, assuming that (1) the number of payments is 7 and the cur- rent interest rate is 6 percent; (2) the number of payments is 14 and the current interest rate is 6 percent; (3) the number of payments is 7 and the cur- rent interest rate is 8 percent; and (4) the number of payments is 14 and the current interest rate is 8 percent. LO4 LO5 Valuing an Asset for the Purpose of Making a Purchasing Decision E 14. Robert Baka owns a service station and has the opportunity to purchase a car-wash machine for $30,000. After carefully studying projected costs and revenues, Baka estimates that the car-wash machine will produce a net cash flow of $5,200 annually and will last for eight years. He determines that an interest rate of 14 percent is adequate for his business. Calculate the present value of the machine to Baka. Does the purchase appear to be a smart business decision? LO4 LO5 Deferred Payment E 15. Antwone Equipment Corporation sold a precision tool machine with com- puter controls to Trudeau Corporation for $200,000 on January 2 and agreed to take payment nine months later on October 2. Assuming that the prevailing annual interest rate for such a transaction is 16 percent compounded quarterly, what is the actual sale (purchase) price of the machine tool? LO4 LO5 Negotiating the Sale of a Business E 16. Eva Prokop is attempting to sell her business to Joseph Khan 2. The company has assets of $3,600,000, liabilities of $3,200,000, and owner’s equity of $400,000. Both parties agree that the proper rate of return to expect is 12 percent; however, they differ on other assumptions. Prokop believes that the business will generate at least $400,000 per year of cash flows for 20 years. Khan thinks that $320,000 in cash flows per year is more reasonable and that only 10 years in the future should be considered. Using Table 2 in the appendix on present value tables, determine the range for negotiation by computing the present value of Prokop’s offer to sell and of Khan’s offer to buy. Problems LO1 LO2 Identification of Current Liabilities, Contingencies, and Commitments LO3 P 1. Listed below are common types of current liabilities, contingencies, and commitments: a. Accounts payable i. Income taxes payable

b. Bank loans and commercial paper j. Property taxes payable c. Notes payable k. Promotional costs d. Dividends payable l. Product warranty liability e. Sales and excise taxes payable m. Vacation pay liability f. Current portion of long-term debt n. Contingent liability g. Payroll liabilities o. Commitment h. Unearned revenues Chapter Assignments 465 Required 1. For each of the following statements, identify the category above to which it gives rise or with which it is most closely associated: 1. A company agrees to replace parts of a product if they fail. 2. An employee earns one day off for each month worked. 3. A company signs a contract to lease a building for five years. 4. A company puts discount coupons in the newspaper. 5. A company agrees to pay insurance costs for employees. 6. A portion of a mortgage on a building is due this year. 7. The board of directors declares a dividend. 8. A company has trade payables. 9. A company has a pending lawsuit against it. 10. A company arranges for a line of credit. 11. A company signs a note due in 60 days. 12. A company operates in a state that has a sales tax. 13. A company earns a profit that is taxable. 14. A company owns buildings that are subject to property taxes. User insight (cid:2) 2. Of the items listed from a to o above, which ones would you not expect to see listed on the balance sheet with a dollar amount? Of those items that would be listed on the balance sheet with a dollar amount, which ones would you con- sider to involve the most judgment or discretion on the part of management? LO2 Notes Payable and Wages Payable P 2. Part A: State Mill Company, whose fiscal year ends December 31, com- pleted the following transactions involving notes payable: 2010 Nov. 25 Purchased a new loading cart by issuing a 60-day 10 percent note for $86,400. Dec. 31 Made the end-of-year adjusting entry to accrue interest expense. 2011 Jan. 24 Paid off the loading cart note. Required 1. Prepare entries in journal form for State Mill Company’s notes payable trans- actions. User insight (cid:2) 2. When notes payable appears on the balance sheet, what other current liability would you look for to be associated with the notes? What would it mean if this other current liability did not appear? Part B: At the end of October, the payroll register for State Mill Com- pany contained the following totals: wages, $185,500; federal income taxes withheld, $47,442; state income taxes withheld, $7,818; Social Security tax withheld, $11,501; Medicare tax withheld, $2,690; medical insurance deductions, $6,400; and wages subject to unemployment taxes, $114,480. Required Prepare entries in journal form to record the (1) monthly payroll and (2) em ployer payroll expenses, assuming Social Security and Medicare taxes equal to the amount for employees, a federal unemployment insurance tax of 0.8 percent, a state unemployment tax of 5.4 percent, and medical insurance premiums for which the employer pays 80 percent of the cost. 466 CHAPTER 10 Current Liabilities and Fair Value Accounting LO2 Product Warranty Liability P 3. The Smart Way Products Company manufactures and sells wireless video cell phones, which it guarantees for five years. If a cell phone fails, it is replaced free, but the customer is charged a service fee for handling. In the past, management has found that only 3 percent of the cell phones sold required replacement under the warranty. The average cell phone costs the company $120. At the beginning of September, the account for estimated liability for product warranties had a credit balance of $104,000. During September, 250 cell phones were returned under the warranty. The company collected $4,930 of service fees for handling. During the month, the company sold 2,800 cell phones. Required 1. Prepare entries in journal form to record (a) the cost of cell phones replaced under warranty and (b) the estimated liability for product warranties for cell phones sold during the month. 2. Compute the balance of the Estimated Product Warranty Liability account at the end of the month.

User insight (cid:2) 3. If the company’s product warranty liability is underestimated, what are the effects on current and future years’ income? LO1 Identification and Evaluation of Current Liabilities P 4. Tony Garcia opened a small dryer repair shop, Garcia Repair Shop, on January 2, 2010. The shop also sells a limited number of dryer parts. In Janu- ary 2011, Garcia realized he had never filed any tax reports for his business and therefore probably owes a considerable amount of taxes. Since he has limited experience in running a business, he has brought you all his business records, including a checkbook, canceled checks, deposit slips, suppliers’ invoices, a notice of annual property taxes of $2,310 due to the city, and a promissory note to his father-in-law for $2,500. He wants you to determine what his business owes the government and other parties. You analyze all his records and determine the following as of December 31, 2010: Unpaid invoices for dryer parts $ 9,000 Parts sales (excluding sales tax) 44,270 Cost of parts sold 31,125 Workers’ salaries 18,200 Repair revenues 60,300 Current assets 16,300 Dryer parts inventory 11,750 You learn that the company has deducted $476 from the two employees’ sal- aries for federal income taxes owed to the government. The current Social Secu- rity tax is 6.2 percent on maximum earnings of $102,000 for each employee, and the current Medicare tax is 1.45 percent (no maximum earnings). The FUTA tax is 5.4 percent to the state and .8 percent to the federal government on the first $7,000 earned by each employee, and each employee earned more than $7,000. Garcia has not filed a sales tax report to the state (5 percent of sales). Required 1. Given these limited facts, determine Garcia Repair Shop’s current liabilities as of December 31, 2010. User insight (cid:2) 2. What additional information would you want from Garcia to satisfy yourself that all current liabilities have been identified? Chapter Assignments 467 User insight (cid:2) 3. Evaluate Garcia’s liquidity by calculating working capital, payables turnover, and days’ payable. Comment on the results. (Assume average accounts pay- able were the same as year-end accounts payable.) LO4 LO5 Applications of Present Value P 5. Andy Corporation’s management took the following actions, which went into effect on January 2, 2010. Each action involved an application of present value. a. A ndy Corporation enters into a purchase agreement that calls for a payment of $500,000 three years from now. b. B ought out the contract of a member of top management for a payment of $50,000 per year for four years beginning January 2, 2011. Required 1. Assuming an annual interest rate of 10 percent and using Tables 1 and 2 in the appendix of present value tables, answer the following questions: a. In action a, what is the present value of the liability for the purchase agreement? b. In action b, what is the cost (present value) of the buyout? User insight (cid:2) 2. Many businesses analyze present value extensively when making decisions about investing in long-term assets. Why is this type of analysis particularly appropriate for such decisions? Alternate Problems LO2 Notes Payable and Wages Payable P 6. Part A: Nazir Corporation, whose fiscal year ended June 30, 2011, com- pleted the following transactions involving notes payable: May 21 Obtained a 60-day extension on an $18,000 trade account payable owed to a supplier by signing a 60-day $18,000 note. Interest is in addition to the face value, at the rate of 14 percent. June 30 Made the end-of-year adjusting entry to accrue interest expense. July 20 Paid off the note plus interest due the supplier. Required 1. Prepare entries in journal form for the notes payable transactions. User insight (cid:2) 2. When notes payable appears on the balance sheet, what other current liability would you look for to be associated with the notes? What would it mean if this other current liability did not appear? Part B: The payroll register for Nazir Corporation contained the following totals at the end of July: wages, $139,125; federal income taxes withheld,

$35,582; state income taxes withheld, $5,863; Social Security tax with- held, $8,626; Medicare tax withheld, $2,017; medical insurance deductions, $4,800; and wages subject to unemployment taxes, $85,860. Required Prepare entries in journal form to record the (1) monthly payroll and (2) employer payroll expenses, assuming Social Security and Medicare taxes equal to the amount for employees, a federal unemployment insurance tax of 0.8 percent, a state unemployment tax of 5.4 percent, and medical insurance premiums for which the employer pays 80 percent of the cost. 468 CHAPTER 10 Current Liabilities and Fair Value Accounting LO2 Product Warranty Liability P 7. Telemix Company is engaged in the retail sale of high-definition televisions (HDTVs). Each HDTV has a 24-month warranty on parts. If a repair under warranty is required, a charge for the labor is made. Management has found that 20 percent of the HDTVs sold require some work before the warranty expires. Furthermore, the average cost of replacement parts has been $60 per repair. At the beginning of January, the account for the estimated l iability for product warranties had a credit balance of $14,300. During January, 146 HDTVs were returned under the warranty. The cost of the parts used in repairing the HDTVs was $8,760, and $9,442 was collected as service revenue for the labor involved. During January, the month before the Super Bowl, Telemix Company sold 450 new HDTVs. Required 1. Prepare entries in journal form to record each of the following: (a) the war- ranty work completed during the month, including related revenue; (b) the estimated liability for product warranties for HDTVs sold during the month. 2. Compute the balance of the Estimated Product Warranty Liability account at the end of the month. User insight (cid:2) 3. If the company’s product warranty liability is overestimated, what are the effects on current and future years’ income? LO4 LO5 Applications of Present Value P 8. The management of K&S, Inc., took the following actions that went into effect on January 2, 2010. Each action involved an application of present value. a. Asked for another fund to be established by a single payment to accumulate to $75,000 in four years. b. Approved the purchase of a parcel of land for future plant expansion. Pay- ments are to start January 2, 2011, at $50,000 per year for five years. Required 1. Assuming an annual interest rate of 8 percent and using Tables 1 and 2 in the appendix of present value tables, answer the following questions: a. In action a, how much will need to be deposited initially to accumulate the desired amount? b. In action b, what is the purchase price (present value) of the land? User insight (cid:2) 2. What is the fundamental reason present value analysis is a useful tool in mak- ing business decisions? LO1 Identification and Evaluation of Current Liabilities P 9. Jose Hernandez opened a small motorcycle repair shop, Hernandez Cycle Repair, on January 2, 2011. The shop also sells a limited number of motorcycle parts. In January 2012, Hernandez realized he had never filed any tax reports for his business and therefore probably owes a considerable amount of taxes. Since he has limited experience in running a business, he has brought you all his business records, including a checkbook, canceled checks, deposit slips, suppliers’ invoices, a notice of annual property taxes of $4,620 due to the city, and a promissory note to his father-in-law for $5,000. He wants you to determine what his business owes the government and other parties. Chapter Assignments 469 You analyze all his records and determine the following as of December 31, 2011: Unpaid invoices for motorcycle parts $ 18,000 Parts sales (excluding sales tax) 88,540 Cost of parts sold 62,250 Workers’ salaries 20,400 Repair revenues 120,600 Current assets 32,600 Motorcycle parts inventory 23,500 You learn that the company has deducted $952 from the two employees’ sala- ries for federal income taxes owed to the government. The current Social Security tax is 6.2 percent on maximum earnings of $102,000 for each employee, and the

current Medicare tax is 1.45 percent (no maximum earnings). The FUTA tax is 5.4 percent to the state and 0.8 percent to the federal government on the first $7,000 earned by each employee, and each employee earned more than $7,000. Hernandez has not filed a sales tax report to the state (5 percent of sales). Required 1. Given these limited facts, determine Hernandez Cycle Repair’s current liabil- ities as of December 31, 2011. User insight (cid:2) 2. What additional information would you want from Hernandez to satisfy yourself that all current liabilities have been identified? User insight (cid:2) 3. Evaluate Hernandez’s liquidity by calculating working capital, payables turn- over, and days’ payable. Comment on the results. (Assume average accounts payable were the same as year-end accounts payable.) ENHANCING Your Knowledge, Skills, and Critical Thinking LO2 Frequent Flyer Plan C 1. JetGreen Airways instituted a frequent flyer program in which passengers accumulate points toward a free flight based on the number of miles they fly on the airline. One point was awarded for each mile flown, with a minimum of 750 miles being given for any flight. Because of competition in 2010, the com- pany began a bonus plan in which passengers received triple the normal mileage points. In the past, about 1.5 percent of passenger miles were flown by passen- gers who had converted points to free flights. With the triple mileage program, JetGreen expects that a 2.5 percent rate will be more appropriate for future years. During 2010, the company had passenger revenues of $966.3 million and passenger transportation operating expenses of $802.8 million before depre- ciation and amortization. Operating income was $86.1 million. What is the appropriate rate to use to estimate free miles? What would be the effect of the estimated liability for free travel by frequent fliers on 2010 net income? Describe several ways to estimate the amount of this liability. Be prepared to discuss the arguments for and against recognizing this liability. 470 CHAPTER 10 Current Liabilities and Fair Value Accounting LO4 LO5 Time Value of Money C 2. In its “Year-End Countdown Sale,” a local Cadillac auto dealer advertised “0% interest for 60 months!”15 What role does the time value of money play in this promotion? Assuming that Cadillac is able to borrow funds at 8 percent interest, what is the cost to Cadillac of every customer who takes advantage of this offer? If you were able to borrow to pay cash for this car, which rate would be more relevant in determining how much you might offer for the car—the rate at which you borrow money or the rate at which Cadillac borrows money? LO2 Nature and Recognition of an Estimated Liability C 3. The decision to recognize and record a liability is sometimes a matter of judgment. People who use General Motors credit cards earn rebates toward the purchase or lease of GM vehicles in relation to the amount of purchases they make with their cards. General Motors chooses to treat these outstanding rebates as a commitment in the notes to its financial statements: GM sponsors a credit card program . . .which offers rebates that can be applied primarily against the purchase or lease of GM vehicles. The amount of rebates available to qualified cardholders (net of deferred program income) was $4.9 billion and $4.7 billion at December 31, 2006, and 2005, respectively.16 Using the two criteria established by the FASB for recording a contingency, explain GM’s reasoning in treating this liability as a commitment in the notes, where it will likely receive less attention by analysts, rather than including it on the income statement as an expense and on the balance sheet as an estimated liability. Do you agree with this position? (Hint: Apply the matching rule.) LO2 LO5 Nature and Recognition of an Estimated Liability C 4. Assume that you work for Theater-At-Home, Inc., a retail company that sells basement movie projection systems for $10,000. Your boss is considering two types of promotions: 1. Offering customers a $1,000 coupon that they can apply to future purchases,

including the purchase of annual maintenance. 2. Offering credit terms that allow payments of $2,000 down and $2,000 per year for four years starting one year after the purchase. Theater-At-Home would have to borrow money at 7 percent interest to finance these credit arrangements. Divide the class into groups. After discussing the relative merits of these two plans, including their implications for accounting and the time value of money, each group should decide on the best alternative. The groups may recommend changes in the plans. A representative of each group should report the group’s findings to the class. LO1 LO3 Short-Term Liabilities and Seasonality; Commitments and Contingencies C 5. Refer to the quarterly financial report near the end of the notes to the finan- cial statements in CVS’s annual report. Is CVS’s a seasonal business? Would you expect short-term borrowings and accounts payable to be unusually high or unusually low at the balance sheet date of December 31, 2008? Read CVS’s note on commitments and contingencies. What commitments and contingencies does the company have? Why is it important to consider this information in connection with payables analysis? Chapter Assignments 471 LO1 Payables Analysis C 6. Refer to CVS’s financial statements in the Supplement to Chapter 5 and to the following data for Walgreens: 2008 2007 2006 Cost of goods sold $42,391 $38,518 $34,240 Accounts payable 4,289 3,734 4,039 Increase in merchandise inventories 412 676 376 Compute the payables turnover and days’ payable for CVS and Walgreens for the past two years. In 2006, CVS had accounts payable of $3,411.6 million, and its merchan- dise inventory increased by $448.0 in 2007. Which company do you think makes the most use of creditors for financing the needs of the operating cycle? Has the trend changed? C H A P T E R 11 Long-Term Assets L ong-term assets include tangible assets, such as land, build- Making a Statement ings, and equipment; natural resources, such as timberland and oil fields; and intangible assets, such as patents and copyrights. INCOME STATEMENT These assets represent a company’s strategic commitments well into Revenues the future. The judgments related to their acquisition, operation, – Expenses and disposal and to the allocation of their costs will affect a com- = Net Income pany’s performance for years to come. Investors and creditors rely on accurate and full reporting of the assumptions and judgments STATEMENT OF that underlie the measurement of long-term assets. OWNER’S EQUITY Beginning Balance + Net Income LEARNING OBJECTIVES – Withdrawals LO1 Define long-term assets, and explain the management issues = Ending Balance related to them. (pp. 474–479) BALANCE SHEET LO2 Distinguish between capital expenditures and revenue Assets Liabilities expenditures, and account for the cost of property, plant, and equipment. (pp. 479–483) Owner’s LO3 Compute depreciation under the straight-line, production, Equity and declining-balance methods. (pp. 483–490) A = L + OE LO4 Account for the disposal of depreciable assets. (pp. 490–494) STATEMENT OF CASH FLOWS LO5 Identify the issues related to accounting for natural resources, Operating activities and compute depletion. (pp. 494–496) + Investing activities + Financing activities LO6 Identify the issues related to accounting for intangible = Change in Cash assets, including research and development costs and + Beginning Balance goodwill. (pp. 497–501) = Ending Cash Balance Purchase, use, and disposal of long-term assets affect all financial statements. 472 DECISION POINT (cid:2) A USER’S FOCUS (cid:2) What long-term assets other than a delivery van might CAMPUS CLEANERS Campus Cleaners have, and how should it account for them? To provide goods and services to customers, businesses need tangi- (cid:2) What are the three common ble long-term assets, such as buildings, machines, or trucks. Among methods of calculating depreciation on tangible long- the issues involved in accounting for long-term assets is how to allo- term assets, and how do the cate their costs over their expected useful lives. For instance, sup-

patterns of depreciation that pose that on January 2, 2010, Campus Cleaners pays $29,000 for a they produce differ? small van that it will use in making deliveries to its customers. The company expects that the van will be driven a total of 150,000 miles over a 5-year period and that at the end of that time, it will be worth $2,000. The table that follows shows the estimated mileage in each of the 5 years that the van is expected to be in use. Campus Cleaners can allocate the cost of the van over the 5 years based on mileage. However, the company has a choice to make because, as you will learn in this chapter, there are three common ways of allocating the cost of a tangible long-term asset over accounting periods. Years Miles 2010 30,000 2011 52,500 2012 45,000 2013 15,000 2014 7,500 Total 150,000 447733 474 CHAPTER 11 Long-Term Assets Management Long-term assets were once called fixed assets, but this term has fallen out of Issues Related to favor because it implies that the assets last forever, which they do not. Long-term assets have the following characteristics: Long-Term Assets (cid:2) They have a useful life of more than one year. This distinguishes them from current assets, which a company expects to use up or convert to LO1 Define long-term assets, cash within 1 year or during its operating cycle, whichever is longer. They and explain the management also differ from current assets in that they support the operating cycle, issues related to them. rather than being part of it. Although there is no strict rule for defining the u seful life of a long-term asset, the most common criterion is that the asset be capable of repeated use for at least a year. Included in this category is equipment used only in peak or emergency periods, such as electric generators. (cid:2) They are used in the operation of a business. Assets not used in the normal course of business, such as land held for speculative reasons or buildings no longer used in ordinary business operations, should be classified as long-term investments, not as long-term assets. (cid:2) They are not intended for resale to customers. An asset that a company Study Note intends to resell to customers should be classified as inventory—not as a A computer that a company long-term asset—no matter how durable it is. For example, a printing press uses in an office is a long- that a manufacturer offers for sale is part of the manufacturer’s inventory, term plant asset. An identical but it is a long-term asset for a printing company that buys it to use in its computer that a company sells operations. to customers is considered Figure 11-1 shows the relative importance of long-term assets in various indus- inventory. tries. Figure 11-2 shows how long-term assets are classified and defines the meth- ods of accounting for them. Plant assets, which are tangible assets, are accounted for through depreciation. (Although land is a tangible asset, it is not depreciated because it has an unlimited life.) Natural resources, which are also tangible assets, are accounted for through depletion. Most intangible assets are accounted for through amortization, the periodic allocation of the cost of the asset to the peri- ods it benefits. However, some intangible assets, including goodwill, are not sub- ject to amortization if their fair value is below the carrying value. Carrying value (also called book value) is the unexpired part of an asset’s cost (see Figure 11-3). Long-term assets are generally reported at carrying FIGURE 11-1 Advertising 18.9% Long-Term Assets as a Percentage of Total Assets for Selected Industries Interstate 47.1% Trucking Auto and 19.6% Home Supply Grocery 43.3% Stores Machinery 32.0% Computers 21.6% 0 5 10 15 20 25 30 35 40 45 50 55 60 Service Industries Merchandising Industries Manufacturing Industries Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006. Management Issues Related to Long-Term Assets 475 FIGURE 11-2 Classification of Long-Term Assets and Methods of Accounting for Them BALANCE SHEET INCOME STATEMENT Long-Term Assets Expenses

Tangible Assets: long-term assets that have physical substance Land is not expensed because it has Land an unlimited life. Plant, Buildings, Equipment Depreciation: periodic allocation (plant assets) of the cost of a tangible long-lived asset (other than land and natural resources) over its estimated useful life Natural Resources: long-term assets purchased for the economic value that can be taken from the land and used up, as with ore, lumber, oil, and gas or other resources contained in the land Mines Depletion: exhaustion of a natural resource through mining, cutting, Timberland pumping, or other extraction, and Oil and Gas Fields the way in which the cost is allocated Intangible Assets: long-term assets that have no physical substance but have a value based on rights or advantages accruing to the owner Patents, Copyrights, Software, Amortization: periodic allocation Trademarks, Licenses, Brands, Franchises, of the cost of an intangible asset to the Leaseholds, Noncompete Covenants, periods it benefits Customer Lists, Goodwill value. If a long-term asset loses some or all of its potential to generate revenue Study Note before the end of its useful life, it is deemed impaired, and its carrying value For an asset to be classified as is reduced. property, plant, and equipment, it All long-term assets are subject to an annual impairment evaluation. Asset must be “put in use,” which means impairment occurs when the carrying value of a long-term asset exceeds its fair it is available for its intended value.1 Fair value is the amount for which the asset could be bought or sold in a purpose. An emergency generator current transaction. For example, if the sum of the expected cash flows from an is “put in use” when it is available asset is less than its carrying value, the asset would be impaired. Reducing car- for emergencies, even if it is never rying value to fair value, as measured by the present value of future cash flows, used. is an application of conservatism. A reduction in carrying value as the result of FIGURE 11-3 Carrying Value of Long-Term Assets on the Balance Sheet Plant Assets Natural Resources Intangible Assets Less Accumulated Depreciation Less Accumulated Depletion Less Accumulated Amortization Carrying Value Carrying Value Carrying Value 476 CHAPTER 11 Long-Term Assets impairment is recorded as a loss. When the market prices used to establish fair Study Note value are not available, the amount of an impairment must be estimated from the best available information. To be classified as intangible, an asset must lack physical In 2004, Apple Computer recognized losses of $5.5 million in asset substance, be long-term, impairments, but it recognized none in subsequent years. A few years earlier, and represent a legal right or in the midst of an economic slowdown in the telecommunications industry, advantage. WorldCom recorded asset impairments that totaled $79.8 billion, the largest impairment write-down in history. Since then, other telecommunications compa- nies, including AT&T and Qwest Communications, have taken large impairment write-downs. Due to these companies’ declining revenues, the carrying value of some of their long-term assets no longer exceeded the cash flows that they were meant to help generate.2 Because of the write-downs, these companies reported large operating losses. Taking a large write-down in a bad year is often called “taking a big bath” because it “cleans” future years of the bad year’s costs and thus can help a com- pany return to a profitable status. In other words, by taking the largest possible loss on a long-term asset in a bad year, companies hope to reduce the costs of depreciation or amortization on the asset in subsequent years.3 In the next few pages, we discuss the management issues related to long- term assets—how management decides whether it will acquire them, how it will finance them, and how it will account for them. Acquiring Long-Term Assets The decision to acquire a long-term asset is a complex process. For example, Apple’s decision to invest capital in establishing its own retail stores throughout

the country required very careful analysis. Methods of evaluating data to make rational decisions about acquiring long-term assets are grouped under a topic called capital budgeting, which is usually covered as a managerial accounting topic. However, an awareness of the general nature of the problem is helpful in understanding the management issues related to long-term assets. To illustrate an acquisition decision, suppose that Apple’s management is considering the purchase of a $100,000 customer-relations software package. Management estimates that the new software will save net cash flows of $40,000 per year for four years, the usual life of new software, and that the software will be worth $20,000 at the end of that period. These data are shown in Table 11-1. To put the cash flows on a comparable basis, it is helpful to use present value tables, such as Tables 1 and 2 in the appendix on present value tables. If the interest rate set by management as a desirable return is 10 percent compounded annually, the purchase decision would be evaluated as follows: Present Value Acquisition cost Present value factor (cid:2) 1.000 1.000 (cid:6) $100,000 ($100,000) Net annual savings in Present value factor (cid:2) 3.170 cash flows (Table 2: 4 periods, 10%) 3.170 (cid:6) $40,000 126,800 Disposal price Present value factor (cid:2) .683 (Table 1: 4 periods, 10%) 0.683 (cid:6) $20,000 13,660 Net present value $ 40,460 Management Issues Related to Long-Term Assets 477 TABLE 11-1 Year 1 Year 2 Year 3 Year 4 Illustration of an Acquisition Decision Acquisition cost ($100,000) Net annual savings in cash flows 40,000 $40,000 $40,000 $40,000 Disposal price 20,000 Net cash flows ($ 60,000) $40,000 $40,000 $60,000 As long as the net present value is positive, Apple will earn at least 10 percent on the investment. In this case, the return is greater than 10 percent because the net present value is a positive $40,460. Moreover, the net present value is large relative to the investment. Based on this analysis, it appears that Apple’s manage- ment should make the decision to purchase. However, in making its decision, it should take other important considerations into account, including the costs of training personnel to use the software. It should also allow for the possibility that because of unforeseen circumstances, the savings may not be as great as expected. Information about acquisitions of long-term assets appears in the investing activities section of the statement of cash flows. In referring to this section of its 2007 annual report, Apple’s management makes the following statement: The company’s total capital expenditures were $822 million dur- ing fiscal 2007. . . . The company currently anticipates it will utilize approximately $1.1 billion for capital expenditures during 2008, approximately $400 million for further expansion of the Compa- ny’s Retail segment and [the remainder] utilized to support normal replacement of existing capital assets. Financing Long-Term Assets When management decides to acquire a long-term asset, it must also decide how to finance the purchase. Many financing arrangements are based on the life of the asset. For example, an automobile loan generally spans 4 or 5 years, whereas a mortgage on a house may span 30 years. For a major long-term acquisition, a company may issue stock, long-term notes, or bonds. Some companies are profitable enough to pay for long-term assets out of cash flows from operations. A good place to study a company’s investing and financing activities is its statement of cash flows, and a good measure of its ability to finance long-term assets is free cash flow. Free cash flow is the amount of cash that remains after deducting the funds a company must commit to continue operating at its planned level. The commit- ments to be covered include current or continuing operations, interest, income taxes, dividends, and net capital expenditures (purchases of plant assets minus sales of plant assets). If a company fails to pay for current or continuing opera- tions, interest, and income taxes, its creditors and the government can take legal

action. Although the payment of dividends is not strictly required, dividends nor- mally represent a commitment to stockholders. If they are reduced or eliminated, stockholders will be unhappy, and the price of the company’s stock will fall. Net capital expenditures represent management’s plans for the future. A positive free cash flow means that a company has met all its cash commit- ments and has cash available to reduce debt or to expand its operations. A negative free cash flow means that it will have to sell investments, borrow money, or issue stock in the short term to continue at its planned level. If free cash flow remains negative for several years, a company may not be able to raise cash by issuing stock or bonds. 478 CHAPTER 11 Long-Term Assets Using data from Apple’s statement of cash flows in its 2007 annual report, Study Note we can compute the company’s free cash flow as follows (in millions): The computation of free cash flow uses net capital Free Cash Flow (cid:2) N et Cash Flows from Operating Activities (cid:4) Dividends expenditures in place of (cid:4) Purchases of Plant Assets (cid:3) Sales of Plant Assets purchases of plant assets (cid:3) sales (cid:2) $5,470 (cid:4) $0 (cid:4) $735 (cid:3) $0 of plant assets when plant assets (cid:2) $4,735 are small or immaterial. This analysis confirms Apple’s strong financial position. Its cash flow from operat- ing activities far exceeds its net capital expenditures of $735 million. A factor that contributes to its positive free cash flow of $4,735 million is that the company pays no dividends. The financing activities section of Apple’s statement of cash flows also indicates that the company, rather than incurring debt for expansion, actually made net investments of $2,312 million. Applying the Matching Rule When a company records an expenditure as a long-term asset, it is deferring an expense until a later period. Thus, the current period’s profitability looks better than it would if the expenditure had been expensed immediately. Management has considerable latitude in making the judgments and estimates necessary to account for all types and aspects of long-term assets. Sometimes, this latitude is used unwisely and unethically. For example, in the infamous WorldCom account- ing fraud, management ordered that certain expenditures which should have been recorded as operating expenses be capitalized as long-term assets and written off over several years. The result was an overstatement of income by about $10 billion, which ultimately led to the second largest bankruptcy in history of U.S. business. To avoid fraudulent reporting of long-term assets, a company’s management must apply the matching rule in resolving two important issues. The first is how much of the total cost of a long-term asset to allocate to expense in the current accounting period. The second is how much to retain on the balance sheet as an asset that will benefit future periods. To resolve these issues, management must answer four important questions about the acquisition, use, and disposal of each long-term asset (see Figure 11-4): FIGURE 11-4 Useful life or holding period of the long-term asset Issues in Accounting for Long-Term Acquisition Assets Decline in unexpired cost Disposal ACQUISITION USE DISPOSAL 1. Measurement 2. Allocation of expired cost 4. Recording of cost to periods benefited of disposals 3. Accounting for subsequent expenditures, such as repairs, maintenance, and additions ACCOUNTING ISSUES Acquisition Cost of Property, Plant, and Equipment 479 1. How is the cost of the long-term asset determined? 2. How should the expired portion of the cost of the long-term asset be allocated against revenues over time? 3. How should subsequent expenditures, such as repairs and additions, be treated? 4. How should disposal of the long-term asset be recorded? Management’s answers to these questions can be found in the company’s annual report under management’s discussion and analysis and in the notes to the finan- cial statements. STOP & APPLY Corus Company had net cash flows from operating activities during the past year of $133,000.

During the year, the company expended $61,000 for property, plant, and equipment; sold property, plant, and equipment for $14,000; and paid dividends of $20,000. Calculate the company’s free cash flow. What does the result tell you about the company? SOLUTION Net cash flows from operating activities $133,000 Purchases of property, plant, and equipment (61,000) Sales of property, plant, and equipment 14,000 Dividends (20,000) Free cash flow $ 66,000 Corus’s operations provide sufficient cash flows to fund its current expansion and dividends without raising additional capital through borrowing or owner investments. Acquisition Cost Expenditure refers to a payment or an obligation to make a future payment for of Property, an asset, such as a truck, or for a service, such as a repair. Expenditures are classi- fied as capital expenditures or revenue expenditures. Plant, and (cid:2) A capital expenditure is an expenditure for the purchase or expansion of a Equipment long-term asset. Capital expenditures are recorded in asset accounts because they benefit several future accounting periods. LO2 Distinguish between capital expenditures and revenue (cid:2) A revenue expenditure is an expenditure made for the ordinary repairs and expenditures, and account for maintenance needed to keep a long-term asset in good operating condition. the cost of property, plant, and For example, trucks, machines, and other equipment require periodic tune- equipment. ups and routine repairs. Expenditures of this type are recorded in expense accounts because their benefits are realized in the current period. Capital expenditures include outlays for plant assets, natural resources, and intangible assets. They also include expenditures for the following: (cid:2) Additions, which are enlargements to the physical layout of a plant asset. For example, if a new wing is added to a building, the benefits from the expen- diture will be received over several years, and the amount paid should be debited to an asset account. 480 CHAPTER 11 Long-Term Assets (cid:2) Betterments, which are improvements to a plant asset but that do not add to the plant’s physical layout. Installation of an air-conditioning system is an example. Because betterments provide benefits over a period of years, their costs should be debited to an asset account. (cid:2) Extraordinary repairs, which are repairs that significantly enhance a plant asset’s estimated useful life or residual value. For example, a complete over- haul of a building’s heating and cooling system may extend the system’s useful life by five years. Extraordinary repairs are typically recorded by reduc- ing the Accumulated Depreciation account; the assumption in doing so is that some of the depreciation previously recorded on the asset has now been eliminated. The effect of the reduction is to increase the asset’s carrying value by the cost of the extraordinary repair. The new carrying value should be depreciated over the asset’s new estimated useful life. The distinction between capital and revenue expenditures is important in apply- ing the matching rule. For example, if the purchase of a machine that will benefit a company for several years is mistakenly recorded as a revenue expenditure, the total cost of the machine becomes an expense on the income statement in the cur- rent period. As a result, current net income will be reported at a lower amount (understated), and in future periods, net income will be reported at a higher amount (overstated). If, on the other hand, a revenue expenditure, such as the routine over- haul of a piece of machinery, is charged to an asset account, the expense of the cur- rent period will be understated. Current net income will be overstated by the same amount, and the net income of future periods will be understated. General Approach to Acquisition Costs The acquisition cost of property, plant, and equipment includes all expenditures Study Note reasonable and necessary to get an asset in place and ready for use. For example, Expenditures necessary to the cost of installing and testing a machine is a legitimate cost of acquiring the

prepare an asset for its intended machine. However, if the machine is damaged during installation, the cost of use are a cost of the asset. repairs is an operating expense, not an acquisition cost. Acquisition cost is easiest to determine when a purchase is made for cash. In that case, the cost of the asset is equal to the cash paid for it plus expenditures for freight, insurance while in transit, installation, and other necessary related costs. Expenditures for freight, insurance while in transit, and installation are included in the cost of the asset because they are necessary if the asset is to function. In accordance with the matching rule, these expenditures are allocated over the asset’s useful life rather than charged as expenses in the current period. Any interest charges incurred in purchasing an asset are not a cost of the asset; they are a cost of borrowing the money to buy the asset and are therefore an operating expense. An exception to this rule is that interest costs incurred dur- ing the construction of an asset are properly included as a cost of the asset.4 As a matter of practicality, many companies establish policies that define when an expenditure should be recorded as an expense or as an asset. For example, small expenditures for items that qualify as long-term assets may be treated as expenses because the amounts involved are not material in relation to net income. Thus, although a wastebasket may last for years, it would be recorded as supplies expense rather than as a depreciable asset. Specific Applications In the sections that follow, we discuss some of the problems of determining the cost of long-term plant assets. Acquisition Cost of Property, Plant, and Equipment 481 Land The purchase price of land should be debited to the Land account. Other Study Note expenditures that should be debited to the Land account include commissions Many costs may be incurred to to real estate agents; lawyers’ fees; accrued taxes paid by the purchaser; costs of prepare land for its intended use preparing the land to build on, such as the costs of tearing down old buildings and condition. All such costs are and grading the land; and assessments for local improvements, such as putting in a cost of the land. streets and sewage systems. The cost of landscaping is usually debited to the Land account because such improvements are relatively permanent. Land is not subject to depreciation because it has an unlimited useful life. Let us assume that a company buys land for a new retail operation. The net Study Note purchase price is $340,000. The company also pays brokerage fees of $12,000, The costs of tearing down legal fees of $4,000, $20,000 to have an old building on the site torn down, and existing buildings can be major. $2,000 to have the site graded. It receives $8,000 in salvage from the old build- Companies may spend millions ing. The cost of the land is $370,000, calculated as follows: of dollars imploding buildings Net purchase price $340,000 so they can remove them and Brokerage fees 12,000 build new ones. Legal fees 4,000 Tearing down old building $20,000 Less salvage 8,000 12,000 Grading 2,000 Total cost $370,000 Land Improvements Some improvements to real estate, such as driveways, parking lots, and fences, have a limited life and thus are subject to depreciation. They should be recorded in an account called Land Improvements rather than in the Land account. Buildings When a company buys a building, the cost includes the purchase price and all repairs and other expenditures required to put the building in usable Like other costs involved in preparing land for use, the cost of implosion is debited to the Land account. Other expenditures debited to the Land account include the purchase price of the land, brokerage and legal fees involved in the purchase, taxes paid by the purchaser, and landscaping. Courtesy of Ariel Bravy, 2009/Used under license from shutterstock.com. 482 CHAPTER 11 Long-Term Assets condition. When a company uses a contractor to construct a building, the cost includes the net contract price plus other expenditures necessary to put the build-

ing in usable condition. When a company constructs its own building, the cost includes all reasonable and necessary expenditures, including the costs of materi- als, labor, part of the overhead and other indirect costs, architects’ fees, insurance during construction, interest on construction loans during the period of con- struction, lawyers’ fees, and building permits. Because buildings have a limited useful life, they are subject to depreciation. Leasehold Improvements Improvements to leased property that become the property of the lessor (the owner of the property) at the end of the lease are called leasehold improvements. For example, a tenant’s installation of light fixtures, carpets, or walls would be considered a leasehold improvement. These improve- ments are usually classified as tangible assets in the property, plant, and equip- ment section of the balance sheet. Sometimes, they are included in the intangible assets section; the theory in reporting them as intangibles is that because they revert to the lessor at the end of the lease, they are more of a right than a tangible asset. The cost of a leasehold improvement is depreciated or amortized over the remaining term of the lease or the useful life of the improvement, whichever is shorter. Leasehold improvements are fairly common in large businesses. A study of large companies showed that 22 percent report leasehold improvements. The percentage is likely to be much higher for small businesses because they generally operate in leased premises.5 Study Note Equipment The cost of equipment includes all expenditures connected with purchasing the equipment and preparing it for use. Among these expenditures The wiring and plumbing of are the invoice price less cash discounts; freight, including insurance; excise taxes a dental chair are included in and tariffs; buying expenses; installation costs; and test runs to ready the equip- the cost of the asset because ment for operation. Equipment is subject to depreciation. they are a necessary cost of preparing the asset for use. Group Purchases Companies sometimes purchase land and other assets for a lump sum. Because land has an unlimited life and is a nondepreciable asset, it must have a separate ledger account, and the lump-sum purchase price must be apportioned between the land and the other assets. For example, suppose a company buys a building and the land on which it is situated for a lump sum of $170,000. The company can apportion the costs by determining what it would have paid for the building and for the land if it had purchased them separately and applying the appropriate percentages to the lump-sum price. Assume that appraisals yield estimates of $20,000 for the land and $180,000 for the build- ing if purchased separately. In that case, 10 percent of the lump-sum price, or $17,000, would be allocated to the land, and 90 percent, or $153,000, would be allocated to the building, as follows: Appraisal Percentage Apportionment Land $ 20,000 10% ($ 20,000 (cid:5) $200,000) $ 17,000 ($170,000 (cid:6) 10%) Building 180,000 90% ($180,000 (cid:5) $200,000) 153,000 ($170,000 (cid:6) 90%) Totals $200,000 100% $170,000 Depreciation 483 STOP & APPLY Match each term below with the corresponding action in the list that follows by writing the appropriate numbers in the blanks: 1. Addition ____ c. Repainting of an existing building 2. Betterment ____ d. Installation of a new roof that extends 3. Extraordinary repair an existing building’s useful life 4. Land ____ e. Construction of a foundation for a new building 5. Land improvement ____ f. Erection of a new storage facility at the 6. Leasehold improvement back of an existing building 7. Buildings ____ g. Installation of partitions and shelves in a 8. Equipment leased space 9. Not a capital expenditure ____ h. Clearing of land in preparation for con- struction of a new building ____ a. Purchase of a computer ____ i. Installation of a new heating system in ____ b. Purchase of a lighting system for a an existing building parking lot SOLUTION a. 8; b. 5; c. 9; d. 3; e. 7; f. 1; g. 6; h. 4; i. 2

Depreciation As we noted earlier, depreciation is the periodic allocation of the cost of a tan- gible asset (other than land and natural resources) over the asset’s estimated LO3 Compute depreciation useful life. In accounting for depreciation, it is important to keep the following under the straight-line, produc- points in mind: tion, and declining-balance (cid:2) All tangible assets except land have a limited useful life, and the costs of methods. these assets must be distributed as expenses over the years they benefit. Physical deterioration and obsolescence are the major factors in limiting a depreciable asset’s useful life. (cid:2) Physical deterioration results from use and from exposure to the ele- ments, such as wind and sun. Periodic repairs and a sound maintenance policy may keep buildings and equipment in good operating order and extract the maximum useful life from them, but every machine or build- ing must at some point be discarded. Repairs do not eliminate the need for depreciation. (cid:2) Obsolescence refers to the process of going out of date. Because of fast- Study Note changing technology and fast-changing demands, machinery and even A computer may be functioning buildings often become obsolete before they wear out. as well as it did on the day Accountants do not distinguish between physical deterioration and obsoles- it was purchased four years cence because they are interested in the length of an asset’s useful life, not in ago, but because much faster, what limits its useful life. more efficient computers have become available, the old (cid:2) Depreciation refers to the allocation of the cost of a plant asset to the computer is now obsolete. periods that benefit from the asset, not to the asset’s physical deterio- ration or decrease in market value. The term depreciation describes the gradual conversion of the cost of the asset into an expense. 484 CHAPTER 11 Long-Term Assets (cid:2) Depreciation is not a process of valuation. Accounting records are not Study Note indicators of changing price levels; they are kept in accordance with the cost Depreciation is the allocation principle. Because of an advantageous purchase price and market conditions, of the acquisition cost of a the value of a building may increase. Nevertheless, because depreciation is a plant asset, and any similarity process of allocation, not valuation, depreciation on the building must con- between undepreciated cost tinue to be recorded. Eventually, the building will wear out or become obso- and current market value is pure lete regardless of interim fluctuations in market value. coincidence. Factors in Computing Depreciation Four factors affect the computation of depreciation: 1. Cost. As explained earlier, cost is the net purchase price of an asset plus all reasonable and necessary expenditures to get it in place and ready for use. 2. Residual value. Residual value is the portion of an asset’s acquisition cost that a company expects to recover when it disposes of the asset. Other terms used to describe residual value are salvage value, disposal value, and trade-in value. 3. Depreciable cost. Depreciable cost is an asset’s cost less its residual value. Study Note For example, a truck that cost $24,000 and that has a residual value of $6,000 would have a depreciable cost of $18,000. Depreciable cost must be allocated It is depreciable cost, not over the useful life of the asset. acquisition cost, that is allocated over a plant asset’s useful life. 4. Estimated useful life. Estimated useful life is the total number of service units expected from a long-term asset. Service units may be measured in terms of the years an asset is expected to be used, the units it is expected to produce, the miles it is expected to be driven, or similar measures. In computing an asset’s estimated useful life, an accountant should consider all relevant information, including past experience with similar assets, the asset’s present condition, the company’s repair and maintenance policy, and current technological and industry trends.

Depreciation is recorded at the end of an accounting period with an adjusting entry that takes the following form: A (cid:2) L (cid:3) OE Dr. Cr. (cid:4)XXX (cid:4)XXX Dec. 31 Depreciation Expense(cid:4)Asset Name XXX Accumulated Depreciation(cid:4)Asset Name XXX To record depreciation for the period Methods of Computing Depreciation Many methods are used to allocate the cost of plant assets to accounting peri- ods through depreciation. Each is appropriate in certain circumstances. The most common methods are the straight-line method, the production method, and an accelerated method known as the declining-balance method. Straight-Line Method When the straight-line method is used to calculate depreciation, the asset’s depreciable cost is spread evenly over the estimated use- ful life of the asset. The straight-line method is based on the assumption that depreciation depends only on the passage of time. The depreciation expense for each period is computed by dividing the depreciable cost (cost of the depreciat- ing asset less its estimated residual value) by the number of accounting periods in the asset’s estimated useful life. The rate of depreciation is the same in each year. Depreciation 485 FOCUS ON BUSINESS PRACTICE How Long Is the Useful Life of an Airplane? Most airlines depreciate their planes over an estimated use- years. Boeing believes the plane could theoretically make ful life of 10 to 20 years. But how long will a properly main- double the number of flights before it is retired. tained plane really last? Western Airlines paid $3.3 million The useful lives of many types of assets can be extended for a new Boeing 737 in July 1968. More than 78,000 flights indefinitely if the assets are correctly maintained, but and 30 years later, this aircraft was still flying for Vanguard proper accounting in accordance with the matching rule Airlines, a no-frills airline. Among the other airlines that have requires depreciation over a “reasonable” useful life. Each owned this plane are Piedmont, Delta, and US Airways. airline that owned the plane would have accounted for the Virtually every part of the plane has been replaced over the plane in this way. Suppose, for example, that a delivery truck cost $20,000 and has an estimated Study Note residual value of $2,000 at the end of its estimated useful life of five years. Under Residual value and useful life the straight-line method, the annual depreciation would be $3,600, calculated as are, at best, educated guesses. follows: Cost (cid:4) Residual Value (cid:2) $20,000 (cid:4) $2,000 (cid:2) $3,600 per year Estimated Useful Life 5 years Table 11-2 shows the depreciation schedule for the five years. Note that in addi- tion to annual depreciation’s being the same each year, the accumulated depre- ciation increases uniformly and the carrying value decreases uniformly until it reaches the estimated residual value. Study Note Production Method The production method is based on the assumption The production method is that depreciation is solely the result of use and that the passage of time plays no appropriate when a company role in the process. If we assume that the delivery truck in the previous example has widely fluctuating rates of has an estimated useful life of 90,000 miles, the depreciation cost per mile would production. For example, carpet be determined as follows: mills often close during the first 2 weeks in July but may Cost (cid:4) Residual Value (cid:2) $20,000 (cid:4) $2,000 (cid:2) $0.20 per mile Estimated Units of Useful Life 90,000 run double shifts in September. With the production method, If the truck was driven 20,000 miles in the first year, 30,000 miles in the sec- depreciation would be in direct ond, 10,000 miles in the third, 20,000 miles in the fourth, and 10,000 miles in the relation to a mill’s units of fifth, the depreciation schedule for the truck would be as shown in Table 11-3. As output. yyou can see, the amount of depreciation each year is directly related to the units TABLE 11-2 Depreciation Schedule, Annual Accumulated Carrying

Straight-Line Method Cost Depreciation Depreciation Value Date of purchase $20,000 — — $20,000 End of first year 20,000 $3,600 $ 3,600 16,400 End of second year 20,000 3,600 7,200 12,800 End of third year 20,000 3,600 10,800 9,200 End of fourth year 20,000 3,600 14,400 5,600 End of fifth year 20,000 3,600 18,000 2,000 486 CHAPTER 11 Long-Term Assets TABLE 11-3 Depreciation Schedule, Annual Accumulated Carrying Production Method Cost Miles Depreciation Depreciation Value Date of purchase $20,000 — — — $20,000 End of first year 20,000 20,000 $4,000 $ 4,000 16,000 End of second year 20,000 30,000 6,000 10,000 10,000 End of third year 20,000 10,000 2,000 12,000 8,000 End of fourth year 20,000 20,000 4,000 16,000 4,000 End of fifth year 20,000 10,000 2,000 18,000 2,000 of use. The accumulated depreciation increases annually in direct relation to these units, and the carrying value decreases each year until it reaches the estimated residual value. The production method should be used only when the output of an asset over its useful life can be estimated with reasonable accuracy. In addition, the unit used to measure the estimated useful life of an asset should be appropriate for the asset. For example, the number of items produced may be an appropriate mea- sure for one machine, but the number of hours of use may be a better measure for another. Declining-Balance Method An accelerated method of depreciation results Study Note in relatively large amounts of depreciation in the early years of an asset’s life and Accelerated depreciation is smaller amounts in later years. This type of method, which is based on the pas- appropriate for assets that sage of time, assumes that many plant assets are most efficient when new and so provide the greatest benefits provide the greatest benefits in their first years. It is consistent with the match- in their early years. Under ing rule to allocate more depreciation to an asset in its earlier years than to later an accelerated method, ones if the benefits it provides in its early years are greater than those it provides depreciation charges will be later on. highest in years when revenue Fast-changing technologies often cause equipment to become obsoles- generation from the asset is cent and lose service value rapidly. In such cases, using an accelerated method highest. is appropriate because it allocates more depreciation to earlier years than to later ones. Another argument in favor of using an accelerated method is that repair expense is likely to increase as an asset ages. Thus, the total of repair and depreciation expense will remain fairly constant over the years. This result naturally assumes that the services received from the asset are roughly equal from year to year. The declining-balance method is the most common accelerated method of depreciation. With this method, depreciation is computed by applying a fixed rate to the carrying value (the declining balance) of a tangible long-term asset. It therefore results in higher depreciation charges in the early years of the asset’s life. Although any fixed rate can be used, the most common rate is a percent- age equal to twice the straight-line depreciation percentage. When twice the straight-line rate is used, the method is usually called the double-declining- balance method. In our example of the straight-line method, the delivery truck had an estimated useful life of five years, and the annual depreciation rate for the truck was therefore 20 percent (100 percent (cid:5) 5 years). Under the double- declining-balance method, the fixed rate would be 40 percent (2 (cid:6) 20 per- cent). This fixed rate is applied to the carrying value that remains at the end Depreciation 487 TABLE 11-4 Annual Accumulated Carrying Depreciation Schedule, Double- Declining-Balance Method Cost Depreciation Depreciation Value Date of purchase $20,000 — — $20,000 End of first year 20,000 (40% (cid:6) $20,000) (cid:2) $8,000 $ 8,000 12,000 End of second year 20,000 (40% (cid:6) $12,000) (cid:2) 4,800 12,800 7,200 End of third year 20,000 (40% (cid:6) $ 7,200) (cid:2) 2,880 15,680 4,320

End of fourth year 20,000 (40% (cid:6) $ 4,320) (cid:2) 1,728 17,408 2,592 End of fifth year 20,000 592* 2,000 *Depreciation is limited to the amount necessary to reduce carrying value to residual value: $2,592 (previous carrying value) (cid:4) $2,000 (residual value) (cid:2) $592. of each year. With this method, the depreciation schedule would be as shown Study Note iin Table 11-4. The double-declining-balance Note that the fixed rate is always applied to the carrying value at the end of method is the only method the previous year. Depreciation is greatest in the first year and declines each year presented here in which after that. The depreciation in the last year is limited to the amount necessary to the residual value is not rreduce carrying value to residual value. deducted before beginning the depreciation calculation. Comparison of the Three Methods Figure 11-5 compares yearly depre- ciation and carrying value under the three methods. The graph on the left shows yyearly depreciation. As you can see, straight-line depreciation is uniform at $3,600 per year over the 5-year period. The double-declining-balance method begins at $8,000 and decreases each year to amounts that are less than straight-line (ultimately, $592). The production method does not generate a regular pattern because of the random fluctuation of the depreciation from year to year. The graph on the right side of Figure 11-5 shows the carrying value under the three methods. Each method starts in the same place (cost of $20,000) and ends at the same place (residual value of $2,000). However, the patterns of car- rying value during the asset’s useful life differ. For instance, the carrying value under the straight-line method is always greater than under the double-declining- balance method, except at the beginning and end of the asset’s useful life. FIGURE 11-5 Yearly Depreciation Carrying Value Graphic Comparison of Three Methods of Determining Depreciation $10,000 $20,000 8,000 16,000 6,000 12,000 4,000 8,000 2,000 4,000 0 0 0 1 2 3 4 5 0 1 2 3 4 5 Years Years Methods Straight-line Production Double-declining-balance 488 CHAPTER 11 Long-Term Assets FOCUS ON BUSINESS PRACTICE Accelerated Methods Save Money! As shown in Figure 11-6, an AICPA study of 600 large com- allow either the straight-line method or an accelerated panies found that the overwhelming majority used the method, and for tax purposes, about 75 percent of the straight-line method of depreciation for financial report- 600 companies studied preferred an accelerated method. ing. Only about 8 percent used some type of accelerated Companies use different methods of depreciation for good method, and 4 percent used the production method. reason. The straight-line method can be advantageous for These figures tend to be misleading about the importance financial reporting because it can produce the highest net of accelerated depreciation methods, however, especially income, and an accelerated method can be beneficial for when it comes to income taxes. Federal income tax laws tax purposes because it can result in lower income taxes. Special Issues in Depreciation Other issues in depreciating assets include group depreciation, depreciation for partial years, revision of depreciation rates, and accelerated cost recovery for tax purposes. Group Depreciation The estimated useful life of an asset is the average length of time assets of the same type are expected to last. For example, the average use- ful life of a particular type of machine may be six years, but some machines in this category may last only two or three years, while others may last eight or nine years or longer. For this reason, and for convenience, large companies group simi- lar assets, such as machines, trucks, and pieces of office equipment, to calculate depreciation. This method, called group depreciation, is widely used in all fields of industry and business. A survey of large businesses indicated that 65 percent used group depreciation for all or part of their plant assets.6 Depreciation for Partial Years To simplify our examples of depreciation,

we have assumed that plant assets were purchased at the beginning or end of an accounting period. Usually, however, businesses buy assets when they are needed and sell or discard them when they are no longer needed or useful. The time of year is normally not a factor in the decision. Thus, it is often necessary to calcu- late depreciation for partial years. Some companies compute depreciation to the nearest month. Others use the half-year convention, in which one-half year of depreciation is taken in the year the asset is purchased and one-half year is taken in the year the asset is sold. 0 10 20 30 40 50 60 70 80 90 Percentage of Companies Using Method dohteM noitaicerpeD FIGURE 11-6 Depreciation Methods Used by Straight-line 99% 600 Large Companies for Financial Accelerated Reporting 8% method Production 4% 100 Source: “Depreciation Methods Used by 600 Large Companies for Financial Reporting.” Copyright © 2007 by AICPA. Reproduced with permission. Depreciation 489 Revision of Depreciation Rates Because a depreciation rate is based on an estimate of an asset’s useful life, the periodic depreciation charge is seldom precise. It is sometimes very inadequate or excessive. Such a situation may result from an underestimate or overestimate of the asset’s useful life or from a wrong estimate of its residual value. What should a company do when it discovers that a piece of equipment that it has used for several years will last a shorter—or longer—time than originally estimated? Sometimes, it is necessary to revise the estimate of use- ful life so that the periodic depreciation expense increases or decreases. Then, to reflect the revised situation, the remaining depreciable cost of the asset is spread over the remaining years of useful life. With this technique, the annual depreciation expense is increased or decreased to reduce the asset’s carrying value to its residual value at the end of its remaining useful life. For example, suppose a delivery truck cost $14,000 and has a residual value of $2,000. At the time of the purchase, the truck was expected to last six years, and it was depreciated on the straight-line basis. However, after two years of intensive use, it is determined that the truck will last only two more years, but its residual value at the end of the two years will still be $2,000. In other words, at the end of the second year, the truck’s estimated useful life is reduced from six years to four years. At that time, the asset account and its related accumulated depreciation account would be as follows: ACCUMULATED DEPRECIATION— DELIVERY TRUCK DELIVERY TRUCK Dr. Cr. Dr. Cr. Cost 14,000 Depreciation, Year 1 2,000 Depreciation, Year 2 2,000 The remaining depreciable cost is computed as follows: Cost (cid:4) Depreciation Already Taken (cid:4) Residual Value $14,000 (cid:4) $4,000 (cid:4) $2,000 (cid:2) $8,000 The new annual periodic depreciation charge is computed by dividing the remain- ing depreciable cost of $8,000 by the remaining useful life of two years. There- fore, the new periodic depreciation charge is $4,000. This method of revising depreciation is used widely in industry. It is also supported by Opinion No. 9 and Opinion No. 20 of the Accounting Principles Board of the AICPA. Special Rules for Tax Purposes Over the years, to encourage businesses Study Note to invest in new plant and equipment, Congress has revised the federal income For financial reporting purposes, tax law to provide an economic stimulus to the economy. For instance, for the objective is to measure tax purposes the law allows rapid write-offs of plant assets through accelerated performance accurately. For tax depreciation, which differs considerably from the depreciation methods most purposes, the objective is to companies use for financial reporting. Tax methods of depreciation are usually minimize tax liability. not acceptable for financial reporting because the periods over which deductions may be taken are often shorter than the assets’ estimated useful lives. The most recent change in the federal income tax law—the Economic Stimulus Act of

2008—allows a small company to expense the first $250,000 of equipment 490 CHAPTER 11 Long-Term Assets expenditures rather than record them as assets and depreciate them over their useful lives. Also, for assets that are subject to depreciation, there is a bonus first-year deduction. These laws are quite complex and are the subject of more advanced courses. STOP & APPLY On January 13, 2010, Chen Company purchased a company car for $47,500. Chen expects the car to last five years or 120,000 miles, with an estimated residual value of $7,500 at the end of that time. During 2011, the car is driven 24,000 miles. Chen’s year-end is December 31. Compute the depre- ciation for 2011 under each of the following methods: (1) straight-line, (2) production, and (3) double-declining-balance. SOLUTION Depreciation computed: (1) Straight-line method: ($47,500 (cid:4) $7,500) (cid:5) 5 years (cid:2) $8,000 (2) Production method: ($47,500 (cid:4) $7,500) (cid:5) 120,000 miles (cid:2) $0.3333 per mile 24,000 miles (cid:6) $0.3333 (cid:2) $8,000* (3) Double-declining-balance method: (1 (cid:5) 5) (cid:6) 2 (cid:2) 0.40 2010: $47,500 (cid:6) 0.40 (cid:2) $19,000 2011: ($47,500 (cid:4) $19,000) (cid:6) 0.40 (cid:2) $11,400 *Rounded Disposal of When plant assets are no longer useful because they have physically dete- Depreciable riorated or become obsolete, a company can dispose of them by discarding them, selling them for cash, or trading them in on the purchase of a new asset. Assets Regardless of how a company disposes of a plant asset, it must record deprecia- tion expense for the partial year up to the date of disposal. This step is required LO4 Account for the disposal because the company used the asset until that date and, under the matching of depreciable assets. rule, the accounting period should receive the proper allocation of deprecia- tion expense. In the next sections, we show how a company records each type of disposal. As our example, we assume that KOT Company purchases a machine on Janu- ary 2, 2009, for $13,000 and plans to depreciate it on a straight-line basis over an estimated useful life of eight years. The machine’s residual value at the end of eight years is estimated to be $600. On December 31, 2014, the balances of the relevant accounts are as follows: Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Disposal of Depreciable Assets 491 Study Note ACCUMULATED DEPRECIATION— MACHINERY MACHINERY When it disposes of an asset, Dr. Cr. Dr. Cr. a company must bring the 13,000 9,300 depreciation up to date and remove all evidence of ownership of the asset, On January 2, 2015, management disposes of the asset. including the contra account Accumulated Depreciation. Discarded Plant Assets A plant asset rarely lasts exactly as long as its estimated life. If it lasts longer than its estimated life, it is not depreciated past the point at which its carrying value equals its residual value. The purpose of depreciation is to spread the depreciable cost of an asset over its estimated life. Thus, the total accumulated depreciation should never exceed the total depreciable cost. If an asset remains in use beyond the end of its estimated life, its cost and accumulated depreciation remain in the ledger accounts. Proper records will thus be available for maintaining control over plant assets. If the residual value is zero, the carrying value of a fully depre- ciated asset is zero until the asset is disposed of. If such an asset is discarded, no gain or loss results. In our example, however, the discarded equipment has a carrying value of $3,700 at the time of its disposal. The carrying value is computed from the T accounts above as machinery of $13,000 less accumulated depreciation of $9,300. A loss equal to the carrying value should be recorded when the machine is discarded, as follows: Assets (cid:2) Liabilities (cid:3) Owner’s Equity MACHINERY LOSS ON DISPOSAL OF MACHINERY Dr. Cr. Dr. Cr. Jan. 2 13,000 Jan. 2 3,700 ACCUMULATED DEPRECIATION-MACHINERY Dr. Cr.

Jan. 2 9,300 Entry in Journal Form: Dr. Cr. A (cid:2) L (cid:3) OE 2015 (cid:3)9,300 (cid:4)3,700 Jan. 2 Accumulated Depreciation—Machinery 9,300 (cid:4)13,000 Loss on Disposal of Machinery 3,700 Machinery 13,000 Disposal of machine no longer in use Gains and losses on disposals of plant assets are classified as other revenues and expenses on the income statement. Study Note When an asset is discarded or Plant Assets Sold for Cash sold for cash, the gain or loss equals cash received minus the The entry to record a plant asset sold for cash is similar to the one just illustrated, carrying value. except that the receipt of cash should also be recorded. The following entries show how to record the sale of a machine under three assumptions about the 492 CHAPTER 11 Long-Term Assets selling price. In the first case, the $3,700 cash received is exactly equal to the $3,700 carrying value of the machine; therefore, no gain or loss occurs: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH Dr. Cr. Jan. 2 3,700 ACCUMULATED DEPRECIATION—MACHINERY Dr. Cr. Jan. 2 9,300 MACHINERY Dr. Cr. Jan. 2 13,000 Entry in Journal Form: Dr. Cr. A (cid:2) L (cid:3) OE 2015 (cid:3)3,700 Jan. 2 Cash 3,700 (cid:3)9,300 Accumulated Depreciation—Machinery 9,300 (cid:4)13,000 Machinery 13,000 Sale of machine for carrying value; no gain or loss In the second case, the $2,000 cash received is less than the carrying value of $3,700, so a loss of $1,700 is recorded: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH LOSS ON SALE OF MACHINERY Dr. Cr. Dr. Cr. Jan. 2 2,000 Jan. 2 1,700 ACCUMLATED DEPRECIATION—MACHINERY Dr. Cr. Jan. 2 9,300 MACHINERY Dr. Cr. Jan. 2 13,000 Entry in Journal Form: Dr. Cr. A (cid:2) L (cid:3) OE 2015 (cid:3)2,000 (cid:4)1,700 Jan. 2 Cash 2,000 (cid:3)9,300 Accumulated Depreciation—Machinery 9,300 (cid:4)13,000 Loss on Sale of Machinery 1,700 Machinery 13,000 Sale of machine at less than carrying value; loss of $1,700 ($3,700 (cid:4) $2,000) recorded Disposal of Depreciable Assets 493 In the third case, the $4,000 cash received exceeds the carrying value of $3,700, so a gain of $300 is recorded: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH GAIN ON SALE OF MACHINERY Dr. Cr. Dr. Cr. Jan. 2 4,000 Jan. 2 300 ACCUMULATED DEPRECIATION—MACHINERY Dr. Cr. Jan. 2 9,300 MACHINERY Dr. Cr. Jan. 2 13,000 Entry in Journal Form: Dr. Cr. A (cid:2) L (cid:3) OE 2015 (cid:3)4,000 (cid:3)300 Jan. 2 Cash 4,000 (cid:3)9,300 Accumulated Depreciation—Machinery 9,300 (cid:4)13,000 Machinery 13,000 Gain on Sale of Machinery 300 Sale of machine at more than the carrying value; gain of $300 ($4,000 (cid:4) $3,700) recorded Exchanges of Plant Assets As we have noted, businesses can dispose of plant assets by trading them in on the purchase of other plant assets. Exchanges may involve similar assets, such as an old machine traded in on a newer model, or dissimilar assets, such as a cement mixer traded in on a truck. In either case, the purchase price is reduced by the amount of the trade-in allowance. Basically, accounting for exchanges of plant assets is similar to accounting for sales of plant assets for cash. If the trade-in allowance is greater than the asset’s carrying value, the company realizes a gain. If the allowance is less, it suffers a loss. (Some special rules apply and are addressed in more advanced courses.) STOP & APPLY Chen Company sold a car, that cost $47,500 and on which $30,400 of accumulated depreciation had been recorded, on January 2, the first day of business of the current year. For each of the following assumptions, prepare the entry in journal form (without explanation) for the disposal. (1) The car was sold for $17,100 cash. (2) The car was sold for $15,000 cash. (3) The car was sold for $20,000 cash. (continued) 494 CHAPTER 11 Long-Term Assets SOLUTION Dr. Cr. (1) Cash 17,100 Automobile 30,400 Accumulated Depreciation—Automobile 47,500 (2) Cash 15,000 Automobile 30,400 Loss on Sale of Automobile 2,100 Accumulated Depreciation—Automobile 47,500 (3) Cash 20,000 Automobile 30,400 Accumulated Depreciation—Automobile 47,500 Gain on Sale of Automobile 2,900

Natural Resources Natural resources are long-term assets that appear on a balance sheet with descriptive titles like Timberlands, Oil and Gas Reserves, and Mineral Depos- its. The distinguishing characteristic of these assets is that they are converted LO5 Identify the issues related to inventory by cutting, pumping, mining, or other extraction methods. They to accounting for natural are recorded at acquisition cost, which may include some costs of develop- resources, and compute ment. As a natural resource is extracted and converted to inventory, its asset depletion. account must be proportionally reduced. For example, the carrying value of oil reserves on the balance sheet is reduced by the proportional cost of the barrels pumped during the period. As a result, the original cost of the oil reserves is gradually reduced, and depletion is recognized in the amount of the decrease. Depletion Depletion refers not only to the exhaustion of a natural resource but also to the proportional allocation of the cost of a natural resource to the units extracted. The way in which the cost of a natural resource is allocated closely resembles the production method of calculating depreciation. When a natural resource is pur- chased or developed, the total units that will be available, such as barrels of oil, tons of coal, or board-feet of lumber, must be estimated. The depletion cost per unit is determined by dividing the cost of the natural resource (less residual value, if any) by the estimated number of units available. The amount of the depletion cost for each accounting period is then computed by multiplying the depletion cost per unit by the number of units extracted and sold. For example, suppose a mine was purchased for $3,600,000 and that it has an estimated residual value of $600,000 and contains an estimated 3,000,000 tons of coal. The depletion charge per ton of coal is $1, calculated as follows: $3,600,000 (cid:4) $600,000 (cid:2) $1 per ton 3,000,000 tons Thus, if 230,000 tons of coal are mined and sold during the first year, the deple- tion charge for the year is $230,000. This charge would be recorded as follows: Natural Resources 495 Assets (cid:2) Liabilities (cid:3) Owner’s Equity ACCUMULATED DEPLETION—COAL DEPOSITS DEPLETION EXPENSE—COAL DEPOSITS Dr. Cr. Dr. Cr. Dec. 31 230,000 Dec. 31 230,000 Entry in Journal Form: Dr. Cr. A (cid:2) L (cid:3) OE Dec. 31 Depletion Expense—Coal Deposits 230,000 (cid:4)230,000 (cid:4)230,000 Accumulated Depletion—Coal Deposits 230,000 To record depletion of coal mine: $1 per ton for 230,000 tons mined and sold On the balance sheet, data for the mine would be presented as follows: Coal deposits $3,600,000 Less accumulated depletion 230,000 $3,370,000 Sometimes, a natural resource is not sold in the year it is extracted. It is important to note that it would then be recorded as a depletion expense in the year it is sold. The part not sold is considered inventory. Depreciation of Related Plant Assets The extraction of natural resources generally requires special on-site buildings Study Note and equipment (e.g., conveyors, drills, and pumps). The useful life of these plant A company may abandon assets may be longer than the estimated time it will take to deplete the resources. equipment that is still in good However, a company may plan to abandon these assets after all the resources have working condition because been extracted because they no longer serve a useful purpose. In this case, they of the expense involved in should be depreciated on the same basis as the depletion. dismantling the equipment and For example, if machinery with a useful life of ten years is installed on an moving it to another site. oil field that is expected to be depleted in eight years, the machinery should be depreciated over the eight-year period, using the production method. That way, each year’s depreciation will be proportional to the year’s depletion. If one-sixth of the oil field’s total reserves is pumped in one year, then the depreciation should be one-sixth of the machinery’s cost.

If the useful life of a long-term plant asset is less than the expected life of the resource, the shorter life should be used to compute depreciation. In such cases, or when an asset will not be abandoned after all reserves have been depleted, other depreciation methods, such as straight-line or declining-balance, are appropriate. Development and Exploration Costs in the Oil and Gas Industry The costs of exploring and developing oil and gas resources can be accounted for under one of two methods. Under successful efforts accounting, the cost of successful exploration—for example, producing an oil well—is a cost of the resource. It should be recorded as an asset and depleted over the estimated life of the resource. The cost of an unsuccessful exploration—such as the cost of a dry well—is written off immediately as a loss. Because of these immediate write-offs, successful efforts accounting is considered the more conservative method and is used by most large oil companies. 496 CHAPTER 11 Long-Term Assets FOCUS ON BUSINESS PRACTICE How Do You Measure What’s Underground? With a Good Guess. Accounting standards require publicly traded energy com- to be audited independently. Nevertheless, it appears that panies to disclose in their annual reports their production some companies, including Royal Dutch/Shell Group, activities, estimates of their proven oil and gas reserves, and have overestimated their reserves and thus overestimated estimates of the present value of the future cash flows those their future prospects. Apparently, some managers at Royal reserves are expected to generate. The figures are not easy Dutch/Shell Group receive bonuses based on the amount to estimate. After all, the reserves are often miles under- of new reserves added to the annual report. When the com- ground or beneath deep water. As a result, these figures pany recently announced that it was reducing its reported are considered “supplementary” and not reliable enough reserves by 20 percent, the price of its stock dropped.7 On the other hand, smaller, independent oil companies argue that the cost of dry wells is part of the overall cost of the systematic development of an oil field and is thus a part of the cost of producing wells. Under the full-costing method, all costs, including the cost of dry wells, are recorded as assets and depleted over the estimated life of the producing resources. This method tends to improve a company’s earnings performance in its early years. The Financial Accounting Standards Board permits the use of either method.8 STOP & APPLY Ouyang Mining Company paid $8,800,000 for land containing an estimated 40 million tons of ore. The land without the ore is estimated to be worth $2,000,000. The company spent $1,380,000 to erect buildings on the site and $2,400,000 on installing equipment. The buildings have an estimated useful life of 30 years, and the equipment has an estimated useful life of 10 years. Because of the remote location, neither the buildings nor the equipment has a residual value. The company expects that it can mine all the usable ore in 10 years. During its first year of operation, it mined and sold 2,800,000 tons of ore. 1. Compute the depletion charge per ton. 4. Determine the depreciation expense for the 2. Compute the depletion expense that year for the equipment under two alterna- Ouyang Mining should record for its first tives: (a) making the expense proportional year of operation. to the depletion, and (b) using the straight- line method. 3. Determine the depreciation expense for the year for the buildings, making it propor- tional to the depletion. SOLUTION $8,800,000 (cid:4) $2,000,000 2,800,000 tons 1. (cid:2) $0.17 per ton 4. a. (cid:6) $2,400,000 (cid:2) $168,000 40,000,000 tons 40,000,000 tons 2. 2,800,000 tons (cid:6) $0.17 per ton (cid:2) $476,000 $2,400,000 b. (cid:6) 1 year (cid:2) $240,000 2,800,000 tons 10 years 3. (cid:6) $1,380,000 (cid:2) $96,600 40,000,000 tons Intangible Assets 497 Intangible Assets An intangible asset is both long term and nonphysical. Its value comes from the

long-term rights or advantages it affords its owner. Table 11-5 describes the most common types of intangible assets—goodwill, trademarks and brand names, LO6 Identify the issues related copyrights, patents, franchises and licenses, leaseholds, software, noncompete to accounting for intangible covenants, and customer lists—and their accounting treatment. Like intangible assets, including research and assets, some current assets—for example, accounts receivable and certain prepaid development costs and goodwill. expenses—have no physical substance, but because current assets are short term, they are not classified as intangible assets. TABLE 11-5 Accounting for Intangible Assets Type Description Usual Accounting Treatment Subject to Amortization and Annual Impairment Test Copyright An exclusive right granted by the federal Record at acquisition cost, and amortize over government to reproduce and sell literary, the asset’s useful life, which is often much musical, and other artistic materials and shorter than its legal life. For example, the computer programs for a period of the cost of paperback rights to a popular novel author’s life plus 70 years. would typically be amortized over a useful life of 2 to 4 years. Patent An exclusive right granted by the federal The cost of successfully defending a patent government for a period of 20 years to make in a patent infringement suit is added to the a particular product or use a specific process. acquisition cost of the patent. Amortize over A design may be granted a patent for the asset’s useful life, which may be less than 14 years. its legal life. Leasehold A right to occupy land or buildings under Company B debits Leasehold for the amount a long-term rental contract. For example, of the purchase price and amortizes it over if Company A sells its right to use a retail the life of the leasehold (10 years). location to Company B for 10 years, Company B has purchased a leasehold. Software Capitalized costs of computer programs Record the amount of capitalizable developed for sale, lease, or internal use. production costs, and amortize over the estimated economic life of the product. Noncompete A contract limiting the rights of others to Record at acquisition cost, and amortize over covenant compete in a specific industry or line of the contract period. business for a specified period. Customer list A list of customers or subscribers. Debit Customer Lists for amount paid, and amortize over the asset’s expected life. Subject to Annual Impairment Test Only Goodwill The excess of the amount paid for a business Debit Goodwill for the acquisition cost, and over the fair market value of the business’s review impairment annually. net assets. Trademark, A registered symbol or name that can be Debit Trademark or Brand Name for the Brand name used only by its owner to identify a product acquisition cost, and amortize it over a or service. reasonable life. Franchise, A right to an exclusive territory or market, Debit Franchise or License for the acquisition License or the right to use a formula, technique, cost, and amortize it over a reasonable life, process, or design. not to exceed 40 years. Source: Accounting for Intangible Assets: From “Accounting Trends & Techniques” (New York: AICPA, 2007). Copyright © 2007 by American Institute of Certified Public Accountants. Reprinted with Permission. 498 CHAPTER 11 Long-Term Assets FIGURE 11-7 Noncompete Intangible Assets Reported Covenants 14.0% by 600 Large Companies Licenses, 18.0% Franchises Software 23.0% Technology Patents 24.8% Customer 41.0% Lists Trademarks, Brand 45.0% Names, Copyrights Goodwill 87.0% 0 10 20 30 40 50 60 70 80 90 100 Percentage of Companies Reporting Each Type of Asset Source: Data from American Institute of Certified Public Accountants, Accounting Trends & Techniques (New York: AICPA, 2007). Figure 11-7 shows the percentage of companies that report the various types of intangible assets. For some companies, intangible assets make up a substantial portion of total assets. For example, Apple Computer’s goodwill, other acquired

intangible assets, and capitalized software costs amounted to $420 million in 2007. How these assets are accounted for has a major effect on Apple’s performance. The purchase of an intangible asset is a special kind of capital expenditure. Such assets are accounted for at acquisition cost—that is, the amount that a com- pany paid for them. Some intangible assets, such as goodwill and trademarks, may be acquired at little or no cost. Even though these assets may have great value and be needed for profitable operations, a company should include them on its balance sheet only if it purchased them from another party at a price established in the mar- ketplace. When a company develops its own intangible assets, it should record the costs of development as expenses. An exception is the cost of internally developed computer software after a working prototype of the software has been developed. Purchased intangible assets are recorded at cost, or at fair value when pur- chased as part of a group of assets. The useful life of an intangible asset is the FOCUS ON BUSINESS PRACTICE Who’s Number-One in Brands? Brands are intangible assets that often do not appear on a Coca-Cola’s brand was valued at almost $67 billion, whereas company’s balance sheet because rather than purchasing the Mercedes-Benz brand was valued at $22 billion. them, the company has developed them over time. A report attempted to value brands by the discounted present value of future cash flows.9 According to the report, the 10 most valuable brands in the world were as follows: Coca-Cola Nokia Microsoft Toyota IBM Disney GE McDonald’s Intel Mercedes-Benz Intangible Assets 499 FOCUS ON BUSINESS PRACTICE Should a Customer List Be Amortized? One of the most valuable intangible assets some companies has a limited useful life. This ruling has benefited businesses have is a list of customers. The Internal Revenue Service has that purchase everything from bank deposits to p harmacy argued that a customer list has an indefinite useful life and prescription files. For example, The New York Times therefore cannot be used to provide tax deductions through Company, a major newspaper, has spent $221 million on amortization, but the U.S. Supreme Court has upheld the subscriber lists and amortized them to the extent of $196 right to amortize the value of a customer list, arguing that it million, leaving a carrying value of $25 million.10 period over which the asset is expected to contribute to future cash flows of the entity. The useful life may be definite or indefinite.11 (cid:2) Definite useful life. A definite useful life means the useful life is subject to a legal limit or can be reasonably estimated. Examples include patents, copy- rights, and leaseholds. Often the estimated useful lives of these assets are less than their legal limits. The cost of an intangible asset with a definite useful life should be allocated to expense through periodic amortization over its useful life in the same way that a building is depreciated. (cid:2) Indefinite useful life. An indefinite useful life means that the useful life of Study Note the asset is not limited by legal, regulatory, contractual, competitive, eco- The cost of mailing lists may be nomic, or other factors. This definition does not imply that these assets last recorded as an asset because forever. Examples can include trademarks and brands. The costs of intangible the mailing lists will be used assets with an indefinite life are not amortized as long as circumstances con- over and over and will benefit tinue to support an indefinite life. future accounting periods. All intangible assets, whether definite or indefinite, are subject to an annual impairment test to determine if the assets justify their value on the balance sheet. If it is determined that they have lost some or all of their value in pro- ducing future cash flows, they should be written down to their fair value or to zero if they have no fair value. The amount of the write-down is shown on the income statement as an impairment charge (deduction) in determining income

from operations. To illustrate these procedures, suppose Water Bottling Company purchases a patent on a unique bottle cap for $36,000. The purchase would be recorded with an entry of $36,000 to the asset account Patents. (Note that if the company developed the bottle cap internally instead of purchasing the patent, the costs of developing the cap—such as researchers’ salaries and the costs of supplies and equipment used in testing—would be expensed as incurred.) Although the patent for the bottle cap will last for 20 years, Water determines that it will sell the product that uses the cap for only six years. The entry to record the annual amortization expense would be for $6,000 ($36,000 (cid:5) 6 years). The Patents account is reduced directly by the amount of the amortization expense. This is in contrast to the treatment of other long-term asset accounts, for which depreciation or depletion is accumulated in separate contra accounts. If the patent becomes worthless before it is fully amortized, the remaining carrying value is written off as a loss by removing it from the Patents account. 500 CHAPTER 11 Long-Term Assets Research and Development Costs Most successful companies carry out research and development (R&D) activi- ties, often within a separate department. Among these activities are development of new products, testing of existing and proposed products, and pure research. The costs of these activities are substantial for many companies. In a recent year, General Motors spent $6.6 billion, or about 4 percent of its revenues, on R&D.12 R&D costs can be even greater in high-tech fields like pharmaceuticals. For example, Abbott Laboratories recently spent $2.3 billion, or 10.2 percent of its revenues, on R&D.13 The Financial Accounting Standards Board requires that all R&D costs be treated as revenue expenditures and charged to expense in the period in which they are incurred.14 The reasoning behind this requirement is that it is too hard to trace specific costs to specific profitable developments. Also, the costs of research and development are continuous and necessary for the success of a busi- ness and so should be treated as current expenses. To support this conclusion, the FASB cited studies showing that 30 to 90 percent of all new products fail and that 75 percent of new-product expenses go to unsuccessful products. Thus, their costs do not represent future benefits. Computer Software Costs The costs that companies incur in developing computer software for sale or lease or for their own internal use are considered research and development costs until the product has proved technologically feasible. Thus, costs incurred before that point should be charged to expense as they are incurred. A product is deemed technologically feasible when a detailed working program has been designed. Once that occurs, all software production costs are recorded as assets and are amortized over the software’s estimated economic life using the straight-line method. Capitalized software costs are becoming more prevalent and, as shown in Figure 11-7, appear on 21 percent of 600 large companies’ balance sheets. If at any time a company cannot expect to realize from the software the amount of the unamortized costs on the balance sheet, the asset should be written down to the amount expected to be realized.15 Goodwill Goodwill means different things to different people. Generally, it refers to a com- pany’s good reputation. From an accounting standpoint, goodwill exists when a purchaser pays more for a business than the fair market value of the business’s net assets. In other words, the purchaser would pay less if it bought the assets separately. Most businesses are worth more as going concerns than as collections of assets. When the purchase price of a business is more than the fair market value of its physical assets, the business must have intangible assets. If it does not have patents, copyrights, trademarks, or other identifiable intangible assets of value, the excess payment is assumed to be for goodwill. Goodwill reflects all the factors

that allow a company to earn a higher-than-market rate of return on its assets, including customer satisfaction, good management, manufacturing efficiency, the advantages of having a monopoly, good locations, and good employee relations. The payment above and beyond the fair market value of the tangible assets and other specific intangible assets is properly recorded in the Goodwill account. The FASB requires that purchased goodwill be reported as a separate line item on the balance sheet and that it be reviewed annually for impairment. If the fair value of goodwill is less than its carrying value on the balance sheet, goodwill Intangible Assets 501 FOCUS ON BUSINESS PRACTICE Wake up, Goodwill Is Growing! As Figure 11-7 shows, 87 percent of 600 large companies Goodwill Percentage of separately report goodwill as an asset. Because much of the (in billions) Total Assets growth of these companies has come through purchasing General Mills $6,835 38% other companies, goodwill as a percentage of total assets Heinz $2,835 28% has also grown. As the table at the right shows, the amount Cisco Systems $9,298 21% of goodwill can be material.16 is considered impaired. In that case, it is reduced to its fair value, and the impair- ment charge is reported on the income statement. A company can perform the fair value measurement for each reporting unit at any time as long as the measure- ment date is consistent from year to year.17 A company should record goodwill only when it acquires a controlling interest in another business. The amount to be recorded as goodwill can be determined by writing the identifiable net assets up to their fair market values at the time of purchase and subtracting the total from the purchase price. For example, suppose a company pays $11,400,000 to purchase another business. If the net assets of the business (total assets (cid:4) total liabilities) are fairly valued at $10,000,000, then the amount of the goodwill is $1,400,000 ($11,400,000 (cid:4) $10,000,000). STOP & APPLY For each of the following intangible assets, indicate (a) if the asset is to be amortized over its useful life or (b) if the asset is not amortized but only subject to annual impairment test: 1. Goodwill 4. Patent 2. Copyright 5. Trademark 3. Brand name SOLUTION 1. b; 2. a; 3. b; 4. a; 5. b 502 CHAPTER 11 Long-Term Assets (cid:2) CAMPUS CLEANERS: REVIEW PROBLEM In the Decision Point at the beginning of this chapter, we pointed out that Campus Cleaners had a choice to make about which depreciation method it would use in allo- cating the cost of its delivery van over a 5-year period. We asked these questions: • What long-term assets other than a delivery van might Campus Cleaners have, and how should it account for them? • What are the three common methods of calculating depreciation on tangible long- term assets, and how do the patterns of depreciation that they produce differ? In addition to its delivery van, Campus Cleaners’ tangible long-term assets might include land, buildings, and equipment, as well as leasehold improvements if it operates out of a rented space. All these assets would be accounted for through depreciation. Cam- pus Cleaners might also have intangible assets, such as a trademark, which would be Comparison of accounted for through amortization. In accounting for its delivery van, Campus Clean- Depreciation Methods ers would have to determine the purchase price, useful life, residual value, and costs of repairs, maintenance, and other expenses incurred in operating the van. The company LO3 LO4 could use any one of the three common methods of calculating depreciation to allo- cate the cost of the van to the accounting periods in which the van serves customers. Required 1. Compute the depreciation expense and carrying value of the delivery van for 2010 to 2014 using the following methods: (a) straight-line, (b) production, and (c) double-declining balance. 2. Assuming the straight-line method is used and that the delivery van is sold for $5,000 on December 31, 2014, show the entry in journal form to record the sale.

3. User insight: What conclusions can you draw from the patterns of yearly depreciation? Campus Cleaners: Review Problem 503 Answers to 1. Depreciation computed: Review Problem 2. Sale recorded on December 31, 2014: 504 CHAPTER 11 Long-Term Assets 3. The pattern of depreciation for the straight-line method differs significantly from the pattern for the double-declining-balance method. In the earlier years, the amount of depreciation under the double-declining-balance method is significantly greater than the amount under the straight-line method. In the later years, the opposite is true. The carrying value under the straight-line method is greater than under the double-declining-balance method at the end of all years except the fifth year. Depreciation under the production method differs from depreciation under the other methods in that it follows no regular pattern. It varies with the amount of use. Consequently, depreciation is greatest in 2011 and 2012, which are the years of greatest use. Use declined significantly in the last two years. Stop & Review 505 STOP & REVIEW LO1 Defi ne long-term assets, Long-term assets have a useful life of more than one year, are used in the opera- and explain the manage- tion of a business, and are not intended for resale. They can be tangible or intan- ment issues related to gible. In the former category are land, plant assets, and natural resources. In the them. latter are patents, trademarks, franchises, and other rights, as well as goodwill. The management issues related to long-term assets include decisions about whether to acquire the assets, how to finance them, and how to account for them. LO2 Distinguish between Capital expenditures are recorded as assets, whereas revenue expenditures are capital expenditures and recorded as expenses of the current period. Capital expenditures include not only revenue expenditures, outlays for plant assets, natural resources, and intangible assets, but also expendi- and account for the cost tures for additions, betterments, and extraordinary repairs that increase an asset’s of property, plant, and residual value or extend its useful life. Revenue expenditures are made for ordi- equipment. nary repairs and maintenance. The error of classifying a capital expenditure as a revenue expenditure, or vice versa, has an important effect on net income. The acquisition cost of property, plant, and equipment includes all expendi- tures reasonable and necessary to get the asset in place and ready for use. Among these expenditures are purchase price, installation cost, freight charges, and insur- ance during transit. The acquisition cost of a plant asset is allocated over the asset’s useful life. LO3 Compute depreciation Depreciation—the periodic allocation of the cost of a plant asset over its estimated under the straight-line, useful life—is commonly computed by using the straight-line method, the produc- production, and tion method, or an accelerated method. The straight-line method is related directly declining-balance to the passage of time, whereas the production method is related directly to use or methods. output. An accelerated method, which results in relatively large amounts of depre- ciation in earlier years and reduced amounts in later years, is based on the assump- tion that plant assets provide greater economic benefits in their earlier years than in later ones. The most common accelerated method is the declining-balance method. LO4 Account for the disposal A company can dispose of a long-term plant asset by discarding or selling it or of depreciable assets. exchanging it for another asset. Regardless of the way in which a company dis- poses of such an asset, it must record depreciation up to the date of disposal. To record the disposal, it must remove the carrying value from the asset account and the depreciation to date from the accumulated depreciation account. When a company sells a depreciable long-term asset at a price that differs from its carry- ing value, it should report the gain or loss on its income statement. In recording

exchanges of similar plant assets, a gain or loss may arise. LO5 Identify the issues Natural resources are depletable assets that are converted to inventory by cutting, related to accounting for pumping, mining, or other forms of extraction. They are recorded at cost as long- natural resources, and term assets. As natural resources are sold, their costs are allocated as expenses compute depletion. through depletion charges. The depletion charge is based on the ratio of the resource extracted to the total estimated resource. A major issue related to this subject is accounting for oil and gas reserves. LO6 Identify the issues The purchase of an intangible asset should be treated as a capital expenditure related to accounting and recorded at acquisition cost. All intangible assets are subject to annual tests for intangible assets, for impairment of value. Intangible assets with a definite life are also amortized including research and annually. The FASB requires that research and development costs be treated as development costs and revenue expenditures and charged as expenses in the periods of expenditure. Soft- goodwill. ware costs are treated as research and development costs and expensed until a 506 CHAPTER 11 Long-Term Assets feasible working program is developed, after which time the costs may be capi- talized and amortized over a reasonable estimated life. Goodwill is the excess of the amount paid for a business over the fair market value of the net assets and is usually related to the business’s superior earning potential. It should be recorded only when a company purchases an entire business, and it should be reviewed annually for possible impairment. REVIEW of Concepts and Terminology The following concepts and terms Depreciation 475 (LO1) License 497 (LO6) were introduced in this chapter: Double-declining-balance Long-term assets 474 (LO1) Accelerated method 486 (LO3) method 486 (LO3) Natural resources 475 (LO1) Additions 479 (LO2) Economic Stimulus Act Noncompete covenant 497 (LO6) of 2008 489 (LO3) Amortization 475 (LO1) Obsolescence 483 (LO3) Estimated useful life 484 (LO3) Asset impairment 475 (LO1) Patent 497 (LO6) Expenditure 479 (LO2) Betterments 480 (LO2) Physical deterioration 483 (LO3) Extraordinary repairs 480 (LO2) Brand name 497 (LO6) Production method 485 (LO3) Franchise 497 (LO6) Capital expenditure 479 (LO2) Residual value 484 (LO3) Free cash flow 477 (LO1) Carrying value 474 (LO1) Revenue expenditure 479 (LO2) Full-costing method 496 (LO5) Copyright 497 (LO6) Software 497 (LO6) Goodwill 497 (LO6) Customer list 497 (LO6) Straight-line method 484 (LO3) Group depreciation 488 (LO3) Declining-balance Successful efforts method 486 (LO3) Intangible assets 475 (LO1) accounting 495 (LO5) Depletion 475 (LO1) Leasehold 497 (LO6) Tangible assets 479 (LO1) Depreciable cost 484 (LO3) Leasehold improvements 482 (LO2) Trademark 497 (LO6) Chapter Assignments 507 CHAPTER ASSIGNMENTS BUILDING Your Basic Knowledge and Skills Short Exercises LO1 Management Issues SE 1. Indicate whether each of the following actions is primarily related to (a) acquisition of long-term assets, (b) evaluating the adequacy of financing of long-term assets, or (c) applying the matching rule to long-term assets. 1. Deciding between common stock and long-term notes for the raising of funds 2. Relating the acquisition cost of a long-term asset to the cash flows generated by the asset 3. Determining how long an asset will benefit the company 4. Deciding to use cash flows from operations to purchase long-term assets 5. Determining how much an asset will sell for when it is no longer useful to the company 6. Calculating free cash flow LO1 Free Cash Flow SE 2. Rak Corporation had cash flows from operating activities during the past year of $97,000. During the year, the company expended $12,500 for dividends; expended $79,000 for property, plant, and equipment; and sold property, plant, and equipment for $6,000. Calculate the company’s free cash flow. What does the result tell you about the company? LO2 Determining Cost of Long-Term Assets